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Thread: RATIOS IN FINANCE AND HOW TO ANALYZE THEM

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    Default RATIOS IN FINANCE AND HOW TO ANALYZE THEM

    RATIOS IN FINANCE AND HOW TO ANALYZE THEM

    Financial ratio analysis is the process of identifying the financial strengths and weaknesses of the firm by properly establishing relationships between the items of the balance sheet and the profit loss account. Financial Analysis can be undertaken by the management of the firm or by parties outside the firm viz owners, creditors, Investors and others. The underlying principle is understanding the past as a prerequisite for anticipating the future. This financial analysis is the starting point for making plans.
    The nature of analysis will differ depending on the purpose of the exercise.
    a. Trade creditors are interested in firm's ability to meet their claim over a short period of time.
    b. Suppliers of long term debts-are concerned with the firm's long term solvency and survival. They analyze the firm's profitability over time, its ability to generate cash to be able to pay interest and repay principal and the relationship betweenvarious sources of funds-capital structure relationships.
    c. Investors- are mostly concerned about the firm's earnings. They repose more confidence in those firms that show steady growth in earnings.
    d. Management are interested in every aspect of the financial analysis. It is their overall responsibility to see that the resources of the firm are used most effectively and efficiently and that the firm is financially sound.
    Nature of Ratio Analysis
    Ratio analysis is a powerful tool of financial analysis. A ratio can be defined as the relationship between two or more things financial analysis, a ratio is used as bencnmark for evaluating the financial position and performance of the firm. The absolute accounting figures reported in the financial statement do not provide a meaningrul understanding of the performance and financial position of a firm. An accounting figure conveys meaning when it is related to some other relevant information. A $100 million net profit may look impressive, but the firm's performance can be said to be good or bad only when the profit figure is related to the firm's investment. The relationship between two accounting figures expressed, mathematically is known as a financial ratio.
    Ratios help to summarise large quantities of financial data and to make qualitative judgement about the performance of a firm financially. A ratio reflecting a relationship helps to form a qualitative judgement.
    STANDARD OF COMPARISON
    The ratio analysis involves comparison for a useful interpretation of the financial statements. A single ratio in itself does not indicate favourable or unfavourable condition. It should be compared with some standard, refer to as the standard of comparism. Standards of comparison may consist of:
    a. Past ratio: i.e. ratios calculated from past financial statements of the same firm.
    b. Competitors ratios i.e. ratios of some selected firms, especially the most progressive and successful competitors, at the same point in time.
    C. Industry ratios i.e. ratios of the industry to which the firm belongs.
    d. Projected ratios i.e. ratios developed using the projected or proforma financial statement of the same firm.
    TYPES OF RATIOS
    Several ratios, calculated from the accounting data can be grouped into various classes according to financial activity or function to be evaluated. They may be classified into the following categorizes.
    (a) Liquidity ratios
    (b) Leverage Ratiops

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    (c) Activity Ratios
    (d) Profitability Ratios
    LIQUIDITY RATIOS
    These measure the ability of the firm to meet the current obligations. In fact, analysis of liquidity needs the preparation cash budgets, cash and fund flow statements, but liquidity ratio by establishing a relationship between cash and other current
    assets to current obligations, provide a quick measure of liquidity.
    A firm should ensure that it does not suffer from lack of liquidity which can result into a poor credit worthiness, loss of creditor's confidence or closure of the company. High degree of liquidity leads to idle assets that earn nothing.
    The most common ratios which indicate the extent of liquidity are:
    (1) Current ratio, quick ratio, cash ratio, interval measure and net working capital ratio.
    (a) Current Ratio: It measures the firm's short term solvency. It is calculated by dividing current assets by current liabilities
    Current ratio = Current assets ÷Current liabilities
    Quick ratio is a more penetrating test or liquidity than current ratio. It remains an important index of the firms liquidity.
    (b) Quick Ratio = Current Assets-Debtors divided by Current Liabilities
    (c)Cash-Ratio:- Since cash is the most liquid asset, financial analysts may examine cash ratio and its equivalent to current liabilities. Trade investments or marketable securities are equivalent of cash, they may therefore, be included in the computation.
    Cash Ratio = Cash and Marketable Securities divided by Current Liabilities
    LEVERAGE RATI0
    Long-term creditors are concerned with the firm's long term financlal strength. In determining this, financial leverage or capital structure ratios are calculated. These ratios indicate mix of funds provided by owners and lenders.
    The manner in which assets are financed has a number or implications.
    1. Debt is more risky from the firm's point of view. The firm
    has to pay interest to debt holders, irrespective and whether profit is made or loss incurred.
    2. The use of debt is advantageous to shareholders in that (a) they can retain control of the firm (b) there earning will be magnified, when the firm earns a rate of return on the total capital employed higher than the interest rate on the borrowed funds. The process of magnifying the shareholder's return through the use of debt is called "financial leverage" or "financial gearing" or "trading on equity.

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    3. A high debt-burdened firm will find difficulty in raising funds from creditors and owners in future.
    DEBT RATIO: This can be used to analyze the long-term solvency of a firm. The firm may be interested in knowing the proportion of the interest- bearing debt in the capital structure.
    TIMES-INTEREST RATIO: Debt ratios are static in nature and fail to indicate the firm's ability to meet interest and other fixed charge obligations. The interest coverage ratio or Times Interest earned is used to test the firm's debt servicing capacity. The interest coverage ratio is computed by dividing earnings before interest and taxes by interest coverage.
    The interest coverage ratio shows the number of times the lnterest charges are covered by funds that are ordinarily available for their payment. Since taxes are computed after interest, interest coverage is calculaied in relation to earnings before taxes.
    Depreciation is a non-cash item, funds equal to depreciation are also available to pay interest charges. We can thus calculate the interest coverage ratio as earnings before depreciation, interest and taxes divided by interest.
    This ratio indicates the extent to which earnings may fall without causing any embarrassment to the firm regarding the payment or the interest charges. A higher ratio is desirable. But too high a ratio indicates that the firm is very conservative in using debt and that it is not using credits to the best advantage of share holders. A lower ratio indicates excessive use of debts or inefficient operations.
    ACTIVITY RATIO
    Funds of creditors and owners invested in various assets generate sales and profits. The better the management of assets, the larger the amount of sales. Activity ratios are employed to evaluate the eficiency with which the firm manages and utlizes is assets. These ratios are also called turn-over ratios because they indicate the speed at which assets are being converted into sales. Activity ratios, thus, involve a relationship between sales and assets. A proper balance between sales and assets generally reflects that assets are managed well. Several activities ratios can be calculated to judge the effectiveness of assets utilization.
    INVENTORY TURNOVER: inventory turnover ratio indicates the efficiency of the firm in producing and selling its products. It is calculated by dividing the cost of goods sold by the average inventory:
    Inventory Turnover = Cost of goods sold÷Average Inventory
    The inventory turnover shows how rapidly the inventory is turnedover into receivables through sales. A high inventory turnover is indicative of good inventory management. A low inventory turnover implies excessive inventory levels than warranted by production and sales activities or a slow moving or obsolete inventory.
    COLLECTION PERIOD: The average number of days for which debtors remain outstanding is called the Average Collection Period (ACP) a can be computed as ACP. The average collection period (ACP) measures the quality of debtors since it indicates the speed of their collection. Short collection period implies the prompt payments by debtors. ACP should be compared against the firm's credit terms and policy to judge its credit and collection efficiency. If the credit period granted by a firm is 35 days and its ACP is 50 days, this reveals that the firm's debtors are outstanding for a longer period than warranted by the credit period. A liberal and inefficient credit and collection performance. This impairs the firm's liquidity.
    PROFITABILITY RATIO
    A company should earn profits to survive and grow over a long period of time. Profits are essential but it would be wrong to assume that every action initiated by management of a company should be aimed at maximizing profits, irrespective of social consequences. But it is a fact that sufficient profits must be earned to sustain the operations of the business, to be able to obtain funds from investors for expansion and growth and to contribute towards the social welfare of the society.
    Profit is the ultimate 'output of a company and it will have no future if it fails to make sufficient profits. The financial manager should continuously evaluate the efticiency of the company in terms of profits. Besides, management, creditors, and owners are also interested in the profitability of the firm. Generally, two major types of profitability ratios are calculated:
    Profitability in relation to sales
    Profitability in relation to investment
    The ratio indicates the average spread between the cost of goods sold and the sales revenue. A high gross profit margin ratio is a sign of good management. It is occasioned by (1) higher sales prices, with constant cost of goods and (i) Lower cost of goods with constant sales prices. Or the combination of both.
    A low gross profit margin reflects higher cost of goods due to:
    a. Firm's inability to purchase raw materials at favourable terms:

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    b. Inefficient utilization of plants and machinery.
    c. Over investment in plants and machinery.
    CAUTIONS IN USING RATIO ANALYSIS
    The ratio analysis is a widely used technique to evaluate thefinancial position and performance of a business. But there are certain problems in using ratios. The analyst should be aware of these problems. The following are some of the limitations of the ratio analysis.
    1. It is difficult to decide on the proper basis of comparison.
    2. The comparison is rendered difficult because of differences in situations of two companies or of one company over years.
    3. The price level changes make the interpretations of ratios
    4. The differencesin the definitions of items make the interpretation of ratios difficult.
    5. The ratios calculated at a point in time are less informative and defective as they suffer from short term changes.
    6. The ratios are generally calculated from past financial invalid. Statements and thus are no indicators of future.

    Though trading on financial markets involves high risk, it can still generate extra income in case you apply the right approach. By choosing a reliable broker such as InstaForex you get access to the international financial markets and open your way towards financial independence. You can sign up here.


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    What is Ratio Analysis

    A ratio is a relationship between two things. For example, if you have an alcohol recipe made using cups of wine and soda for every bottle of white, then a ratio would be the percentage of each type of drink. Ratios can also be represented by diagrams such as those below. There are always 3 glasses of wine for every two glasses of soda.

    Beer has a higher percentage of sugar in it than soda does, so it has more calories. That being said, the calories are not evenly distributed. The most common ratio of beer and soda drinkers are 2:1:1. But there are other ratios that make up that percentage. For instance, a ratio of 2:1:1 can also be represented by a diagram.

    The more alcohol and soda you drink, the greater your chance of getting intoxicated. This is because alcohol and caffeine raise your blood pressure and increase the rate at which your heart beats. Both of those things cause the blood to carry more fluid and less blood to your brain.

    So, if you are going to drink the amount of either type of drink, it would be a good idea to drink a little bit less of the first and a little bit more of the second. However, if you are going to take more than one type of beverage, you should drink them together. This will provide you with the benefits of both types of drinks but also provide you with a better balance of these substances.

    One important thing to know about drinking is that it is not a "safe" way to drink. If you have had a drink, you know that the alcohol and other toxins and chemicals have entered your system. These toxins and chemicals are very dangerous. If you take more than one type of drink at a time, you are increasing the risk of absorbing more of these substances into your bloodstream. It might seem like a minor difference, but many cases of poisoning or alcohol poisoning can be traced to drinking too much alcohol over a period of time.

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    If you are going to drink, you need to have two glasses of water between every two cups that you drink. This is a basic rule of thumb for safety, but is not always followed by everyone. If you can, you should always take two to three gulps of water after you finish your first drink.

    Also, you need to drink the same amount of drinks every day. Although this may seem obvious, people often take too much in between drinks. When you go to the store to buy drinks, you can either get drinks that contain more calories than you need or you can get drinks that contain fewer calories than you need.

    Alcohol and sugar are the two biggest contributors to weight gain in our society, so it is no wonder that dieting is so important. If you have more than half of your calories coming from either of those two sources, it is very likely that you are gaining weight. You can lose weight easily and keep it off if you follow some simple guidelines. Find out what are ratios for drinking and the percentage of your daily calories that come from alcohol and sugar, and you will shed some serious pounds in no time.

    There are many different drinks that can be high in calories and add to your total calories. Alcohol drinks, sodas, and even juices are usually very high in calories. It is not surprising that many dieters are unhappy with their weight and try to make changes to lose weight. Many people say that drinking more water is one of the best ways to get rid of excess pounds and feel good about themselves. Drinking water makes you feel full, which leads to less hunger and less food cravings which mean that you will not be tempted to snack as much.

    Diet drinks are also very high in calories and should be limited to only when you really need them. If you do choose to consume diet drinks, make sure they contain zero calories and are of the purest quality. This includes drinking the recommended daily amount of water.

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    Drinking plenty of water will also help you lose weight by flushing your body of excess fat and cleansing your system of toxins. Drinking a glass of water with each meal, drinking eight glasses a day, and getting a large number of servings of fruit and vegetable will all help you get your body into a healthy state that helps keep you feeling full and prevents you from becoming overweight.

    Rounding out the four main types of ratio analysis, this process is designed to provide quantitative insight into the financial information contained in an organization's financial statement. This analysis compares certain key terms, such as assets, liabilities, revenue, expenses, balance sheets, assets, liabilities, net worth, and other similar items in an effort to find the most reliable and relevant information possible. As such, it is crucial that the analysis used is precise and comprehensive.

    The first type of analysis looks at current and past trends and compares them with the company's current financial performance. In many cases, this analysis can reveal a pattern of similar behavior over several years.

    Other types of analysis to look at data in the future, and use that data to predict what will occur in the future. As such, these ratios take into account the possibility that the same trends that occurred in the past will occur again. When an analyst utilizes this kind of ratio analysis, he is attempting to figure out how and when those patterns will repeat themselves.

    Of course, it is not uncommon for some financial companies to utilize a mixture of both types of analyses. This allows them to gain a more accurate picture of the future financial health of their business. While it may be tempting to assume that the use of different methods of analyzing ratios would result in inconsistent and unreliable results, the reality is very different.

    Because the use of several methods of ratio analysis can produce very consistent results, it is often possible to use a single indicator to generate a range of different ratios. Using one indicator from a variety of analysis methods will help provide investors with a much more complete picture of the financial health of an organization.

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    While not everyone can rely on a single source of information in order to correctly determine proper ratios, it is possible to learn the basic principles of how to do so. Many businesses are well aware of the importance of proper ratios and can provide investors with helpful resources for determining these ratios. For those companies that cannot provide such resources, it may be necessary to seek outside financial advice or to hire an accountant with specialized training in the subject matter.

    While the process of figuring out the proper ratios involved in the analysis of a company's financial health can take time, it is definitely worth the effort. As such, investors should be prepared to spend time and effort researching different types of analysis and choosing the most appropriate ones for their particular situations.

    When an investor finds the proper analysis for a company, they will have a much better sense of whether the company's management plans to be a successful business in the future. Although most successful businesses make good decisions based on sound financial strategies, it is not uncommon for an organization to make decisions that ultimately result in financial problems in the long run.

    Though trading on financial markets involves high risk, it can still generate extra income in case you apply the right approach. By choosing a reliable broker such as InstaForex you get access to the international financial markets and open your way towards financial independence. You can sign up here.


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