RATIO ANALYSIS
Financial ratios help external stakeholders, and enterprise managers know how well or poorly a business is performing and pinpoint areas that could do with improvement. Companies can also compare themselves to the competition or to diverse companies in other industries. Size need not be an issue since ratios standardize accounting relationships to provide management with a raw reckoning of financial status and trends.
To better categorize them, financial ratios are generally divided into seven principal classes:
• LIQUIDITY RATIOS,
• ACTIVITY RATIOS,
• LEVERAGE/CAPITAL STRUCTURE RATIOS,
• COVERAGE RATIOS,
• PROFITABILITY RATIOS,
• MARKET PROSPECTS RATIOS, AND
• EARNINGS QUALITY
LIQUIDITY RATIOS
Current Ratio gauges the firm’s ability to meet short-term obligations within a given period (usually up to 1 year). It is a measure of Liquidity. The higher your Current Ratio is, the greater your short-term solvency. Although there are several ratios which indicate the liquidity of a company, the Current Ratio can provide us with all the information we need. To be really useful we must compare it over at least three years. The Current Ratio is the ratio of total Current Assets to total Current Liabilities. Current Ratio = Current Assets / Current Liabilities Current assets include cash and bank balances; the inventory of raw materials, work-in-process, and finished goods; marketable securities; borrowers (net of provision for bad and doubtful debts); bills receivable; and prepaid expenses. Current liabilities consist of accounts payable, current portion of long-term debt, accrued salaries, and accrued taxes. When interpreting the Current Ratio, do not discount Asset Quality. Even though two companies have the same current ratio, the one with a high percentage of current assets in the form of cash and receivables is more liquid than that with a high percentage held in inventories. A current ratio of 2:1 is considered satisfactory. An excellent indicator of asset quality is the Quick Ratio. Quick ratio or Acid Test is the ratio of Cash and Cash Equivalents, Marketable Securities, and Accounts Receivable to Current Liabilities. It measures the ability of your company to pay its debts by using Cash and Cash Equivalent Current Assets. Quick ratio is computed as follows: Cash + Marketable Securities + Receivables / Current Liabilities Working Capital the money remaining if a company paid its Current Liabilities (debts payable within one year of the balance sheet date) from its current assets. Working Capital is computed as follows: Working Capital = Current Assets – Current Liabilities You do: input formulas for the Current Ratio, Quick ratio, & Working Capital for each year on your Pro forma Balance Sheet ACTIVITY RATIOS Accounts Receivable Turnover is the ratio of net credit sales of your business to average Accounts Receivable. It estimates the health of your customer base using the number of times you collect your average Accounts Receivable balance annually. Accounts Receivable Turnover is computed as follows: Receivable Turnover = Net Credit Sales / Average Receivables You can compute your Average Collection Period: ACP = 365 / Receivable Turnover Compare the ACP with your credit terms to determine the efficiency of your credit management. If your credit terms are 2/10, net 30, an ACP of 65 days …show more content…
It measures how effectively your company is managing its working capital. The shorter the cash conversion cycle, the better the company is managing working capital, because cash is tied up for a relatively shorter period.
Think back to the last time we discussed Cash Flow.
What dimension does this add to that discussion?
We first need to convert the turnover measures (as previously done) to number of days.
Average Collection Period (ACP) (Days) = 365/receivables turnover ratio
Average Inventory Turnover Period (AIP) (Days) = 365/inventory turnover ratio
Average Payables Turnover Period (APP) (Days) = 365/payables turnover ratio
Calculate the Cash Conversion Cycle using the following formula:
CCC = ACP + AIP − APP
(Where ACP is average days of receivables outstanding, AIP is average days of inventory outstanding and APP is average days of payables outstanding)
You do: input formulas for the Gross Profit Margin, Net Profit Margin, Return on Assets, Return on Shareholders ' Equity, & Cash Conversion Cycle Pro Forma Balance Sheet
I want all ratios in the same location on your spreadsheet.
ASSESSING EARNINGS
Financial ratios help external stakeholders, and enterprise managers know how well or poorly a business is performing and pinpoint areas that could do with improvement. Companies can also compare themselves to the competition or to diverse companies in other industries. Size need not be an issue since ratios standardize accounting relationships to provide management with a raw reckoning of financial status and trends.
To better categorize them, financial ratios are generally divided into seven principal classes:
• LIQUIDITY RATIOS,
• ACTIVITY RATIOS,
• LEVERAGE/CAPITAL STRUCTURE RATIOS,
• COVERAGE RATIOS,
• PROFITABILITY RATIOS,
• MARKET PROSPECTS RATIOS, AND
• EARNINGS QUALITY
LIQUIDITY RATIOS
Current Ratio gauges the firm’s ability to meet short-term obligations within a given period (usually up to 1 year). It is a measure of Liquidity. The higher your Current Ratio is, the greater your short-term solvency. Although there are several ratios which indicate the liquidity of a company, the Current Ratio can provide us with all the information we need. To be really useful we must compare it over at least three years. The Current Ratio is the ratio of total Current Assets to total Current Liabilities. Current Ratio = Current Assets / Current Liabilities Current assets include cash and bank balances; the inventory of raw materials, work-in-process, and finished goods; marketable securities; borrowers (net of provision for bad and doubtful debts); bills receivable; and prepaid expenses. Current liabilities consist of accounts payable, current portion of long-term debt, accrued salaries, and accrued taxes. When interpreting the Current Ratio, do not discount Asset Quality. Even though two companies have the same current ratio, the one with a high percentage of current assets in the form of cash and receivables is more liquid than that with a high percentage held in inventories. A current ratio of 2:1 is considered satisfactory. An excellent indicator of asset quality is the Quick Ratio. Quick ratio or Acid Test is the ratio of Cash and Cash Equivalents, Marketable Securities, and Accounts Receivable to Current Liabilities. It measures the ability of your company to pay its debts by using Cash and Cash Equivalent Current Assets. Quick ratio is computed as follows: Cash + Marketable Securities + Receivables / Current Liabilities Working Capital the money remaining if a company paid its Current Liabilities (debts payable within one year of the balance sheet date) from its current assets. Working Capital is computed as follows: Working Capital = Current Assets – Current Liabilities You do: input formulas for the Current Ratio, Quick ratio, & Working Capital for each year on your Pro forma Balance Sheet ACTIVITY RATIOS Accounts Receivable Turnover is the ratio of net credit sales of your business to average Accounts Receivable. It estimates the health of your customer base using the number of times you collect your average Accounts Receivable balance annually. Accounts Receivable Turnover is computed as follows: Receivable Turnover = Net Credit Sales / Average Receivables You can compute your Average Collection Period: ACP = 365 / Receivable Turnover Compare the ACP with your credit terms to determine the efficiency of your credit management. If your credit terms are 2/10, net 30, an ACP of 65 days …show more content…
It measures how effectively your company is managing its working capital. The shorter the cash conversion cycle, the better the company is managing working capital, because cash is tied up for a relatively shorter period.
Think back to the last time we discussed Cash Flow.
What dimension does this add to that discussion?
We first need to convert the turnover measures (as previously done) to number of days.
Average Collection Period (ACP) (Days) = 365/receivables turnover ratio
Average Inventory Turnover Period (AIP) (Days) = 365/inventory turnover ratio
Average Payables Turnover Period (APP) (Days) = 365/payables turnover ratio
Calculate the Cash Conversion Cycle using the following formula:
CCC = ACP + AIP − APP
(Where ACP is average days of receivables outstanding, AIP is average days of inventory outstanding and APP is average days of payables outstanding)
You do: input formulas for the Gross Profit Margin, Net Profit Margin, Return on Assets, Return on Shareholders ' Equity, & Cash Conversion Cycle Pro Forma Balance Sheet
I want all ratios in the same location on your spreadsheet.
ASSESSING EARNINGS