RATIO ANALYSIS-
BALANCE SHEET RATIOS
DT 05 JAN 2020
Assets = Liabilities + Shareholders’ Equity
Assets are
(1) Fixed or Long Term Assets : Land, Buildings, plant and Machinery, Vehicles, Furniture, Fixtures and so on) Less Depreciation
(2) Long-term investments such as stocks and bonds or real estate, or long term investments made in other companies.
(3) Current Assets (Cash, Cash Equivalents, Inventory, Accounts receivable, prepaid expenses etc)
Liabilities are
(1) Shareholders' Equity - Equity and Retained earnings
(2) Long term Liabilities - Bank Loan, Mortgages, and other long term loans
(3) Current Liabilities :- Short term debt, Accounts payable, current portion of long term debt
What are the types of Balance sheet Analysis?
(1) Vertical Analysis (2) Horizontal Analysis (3) Common size Analysis
What are Balance Sheet Ratios ? 4 TYPES
Efficiency Ratios, Liquidity Ratios, Solvency Ratios and Profitability Ratios
Efficiency Ratios are Inventory Turnover Ratio, Asset Turnover Ratio, Receivable Turnover ratio, Payable Turnover Ratio
Liquidity Ratios are - Current Ratio, Quick Ratio, cash Ratio
Solvency Ratios are - Debt to Equity Ratio, debt/interest service coverage ratio, Debt to Asset Ratio
Profitability Ratios are -Return On Equity, Return On Assets, Return On Capital Employed
1. Efficiency Ratios :- Inventory Turnover Ratio, Asset Turnover Ratio, Receivable Turnover ratio, Payable Turnover Ratio
The efficiency formula is = output / input, and you can multiply the result by 100 to get work efficiency as a percentage
How to increase the output? How to decrease the input? These are 2 ways of improving the efficiency Ratios. Improve the numerator (sales/cost of goods sold) or decrease the denominator
Inventory Turnover Ratio
FORMULA
COST OF GOODS SOLD /
(AVERAGE INVENTORY)
WHERE
AVERAGE INVENTORY = (OPENING INVENTORY + CLOSING INVENTORY) / 2
Notes :
1. Cost of Goods sold is available in Income Statement
2. closing Inventory and Opening Inventory are in Balance sheet
Inventory turnover ratio measures the number of times inventory is sold or consumed in a given time period. It is calculated by dividing the cost of goods sold (COGS) by average inventory.
A good inventory turnover ratio is between 5 and 10 for most industries, which indicates that you sell and restock your inventory every 1-2 months. This ratio strikes a good balance between having enough inventory on hand and not having to reorder too frequently
A low inventory turnover ratio shows that a company may be overstocking or deficiencies in the product line or marketing effort. However, a higher inventory turnover ratio does not always mean better performance. It sometimes may indicate inadequate inventory level, which may result in decrease in sales.
Asset Turnover Ratio
Formula=
TOTAL SALES /
AVERAGE ASSETS
WHERE
AVERAGE ASSETS =
(Beginning Assets + Ending Assets)/2
The asset turnover ratio measures the efficiency of a company's assets to generate more sales.
We can calculate ratio as a percentage also. i.e., net sales as a percentage of total assets.
Comparisons are valid only within the same sectors. Within the same sector, a Higher ratio is generally preferred. Lower ratio means - assets are inefficiently used.
Between sectors - technologies vary and asset bases vary. So, no comparison is possible.
Accounts Receivable Turnover ratio
Also Known as Debtors Turnover Ratio
Formula =
NET SALES /
AVERAGE ACCOUNTS RECEIVABLE
Net sales = Sales on credit - sales returns - sales allowances.
Average Accounts receivable = (Beginning AR + Ending AR)/2
An AR turnover ratio of 7.8 has more analytical value if you can compare it to the average for your industry. An industry average of 10 means Company X is lagging behind its peers, while an average ratio of 5.7 would indicate they're ahead of the pack
Accounts Payable Turnover Ratio
Also Known as Creditors Turnover Ratio
The accounts payable turnover ratio measures how quickly a business makes payments to creditors and suppliers that extend lines of credit.
FORMULA =
TOTAL PURCHASES /
AVERAGE ACCOUNTS PAYABLE
Average Accounts Payable = (Beginning AP + Ending AP)/2
Key Takeaways :
A higher accounts payable ratio indicates that a company pays its bills in a shorter amount of time than those with a lower ratio.
Low AP ratios could signal that a company is struggling to pay its bills, but that is not always the case. It could be using its cash strategically.
Businesses that rely on lines of credit typically benefit from a higher ratio because suppliers and lenders use this metric to gauge the risk they are taking.
LIQUID RATIOS
Liquidity Ratios are Current Ratio, Quick Ratio Or Acid Test Tario, Cash ratio.
Current assets are those which can be converted into cash within one year.
Current liabilities are obligations expected to be paid within one year.
Liquidity is a measure of the ability of a debtor to pay their debts as and when they fall due. It is usually expressed as a ratio or a percentage of current liabilities. Liquidity is the ability to pay short-term obligations.
As a general rule, a current ratio below 1.00 could indicate that a company might struggle to meet its short-term obligations, whereas ratios of 1.50 or greater would generally indicate ample liquidity.
FORMULA :
Current ratio is a comparison of current assets to current liabilities, calculated by dividing your current assets by your current liabilities. Potential creditors use the current ratio to measure a company's liquidity or ability to pay off short-term debts.
CURRENT RATIO=
CURRENT ASSETS/
CURRENT LIABILITIES
Current Assets are : (1) Cash and cash equivalents (2) Marketable securities (3) Accounts receivables (4) Inventories
Current Liabilities are : (1) Short-term debt (2) Accounts payables (3) Accrued liabilities and other debts (4) current portion of Long term debt
QUICK OR ACID TEST RATIO=
QUICK ASSETS/
CURRENT LIABILITIES
Where Quick Assets = Current Assets- Inventories
CASH RATIO=
(CASH+ CASH EQUIVALENTS)/
CURRENT LIABILITIES
Key Takeaways
The acid-test, or quick ratio, is seen as more useful than the often-used current ratio since the acid-test excludes inventory, which can be hard to quickly liquidate.
In the best-case scenario, a company should have a ratio of 1 or more, suggesting the company has enough cash to pay its bills.
Too low a ratio can suggest a company is cash-strapped, but in some cases, it just means a company is dependent on inventory, like retailers.
Too high a ratio could mean a company is sitting on cash, but in some cases, that's just industry-specific, like with some tech companies.
SOLVENCY RATIOS
A solvency ratio indicates whether a company's cash flow is sufficient to meet its long-term liabilities and thus is a measure of its financial health.
The main solvency ratios are the : Debt to Equity Ratio, debt/interest service coverage ratio, Debt to Asset Ratio
DEBT TO EQUITY RATIO
The debt-to-equity (D/E) ratio is calculated by dividing a company's total liabilities by its shareholder equity.
FORMULA=
TOTAL LIABILITIES OR DEBT/
SHAREHOLDERS' EQUITY
Key Takeaways :
The debt-to-equity (D/E) ratio can be used to evaluate how much leverage a company is using.
Higher leverage ratios tend to indicate a company or stock with higher risk to shareholders.
However, the D/E ratio is difficult to compare across industry groups where ideal amounts of debt will vary.
Investors will often modify the D/E ratio to focus on long-term debt only because the risk of long-term liabilities are different than for short-term debt and payables.
DEBT/INTEREST SERVICE COVERAGE RATIO
FORMULA=
EBIT OR NET OPERATING INCOME/
total amount of principal and interest payments required for a given period to obtain net operating income.
A debt service coverage ratio of 1 or above indicates that a company is generating sufficient operating income to cover its annual debt and interest payments. As a general rule of thumb, an ideal ratio is 2 or higher. A ratio that high suggests that the company is capable of taking on more debt
DEBT TO ASSETS RATIO
FORMULA=
TOTAL DEBT (LONG TERM+ SHORT TERM)/
TOTAL ASSETS (LONG TERM+CURRENT)
Key Takeaways
The total-debt-to-total-assets ratio shows the degree to which a company has used debt to finance its assets.
The calculation considers all of the company's debt, not just loans and bonds payable, and considers all assets, including intangibles.
If a company has a total-debt-to-total-assets ratio of 0.4, 40% of its assets are financed by creditors, and 60% are financed by owners (shareholders) equity.
PROFITABILITY RATIOS
Most used Profitability Ratios are -Return On Equity, Return On Assets, Return On Capital Employed
RETURN ON EQUITY
Return on Equity is an important determinant which shows how the company is managing the capital of shareholder. Higher the ROE, better it is for shareholders. It is calculated by dividing the net Profit by the shareholder’s equity.
FORMULA=
NET PROFIT/
SHAREHOLDERS' EQUITY
To calculate ROE, analysts simply divide the company's net income by its average shareholders' equity.
A higher ROE is usually better while a falling ROE may indicate a less efficient usage of equity capital.
RETURN ON ASSETS
FORMULA=
NET PROFIT/
TOTAL(AVERAGE) ASSETS
You can find net profit at the bottom of your income statement. Total assets are your company's liabilities plus your equity.
The higher the ROA number, the better, because the company is earning more money on less investment. Remember total assets is also the sum of its total liabilities and shareholder's equity.
Return on assets gives an indication of the capital intensity of the company, which will depend on the industry; companies that require large initial investments will generally have lower return on assets. ROAs over 5% are generally considered good.
RETURN ON CAPITAL EMPLOYED
FORMULA FOR ROCE =
EBIT/
CAPITAL EMPLOYED(TOTAL ASSETS- CURRENT LIABILITIES)
ROCE is calculated by dividing a company's earnings before interest and tax (EBIT) by its capital employed. In a ROCE calculation, capital employed means the total assets of the company with all liabilities removed.
A higher ROCE shows a higher percentage of the company's value can ultimately be returned as profit to stockholders. As a general rule, to indicate a company makes reasonably efficient use of capital, the ROCE should be equal to at least twice current interest rates
Key Takeaways
Return on capital employed (ROCE) and return on investment (ROI) are two profitability ratios that measure how well a company uses its capital.
ROCE looks at earnings before interest and taxes (EBIT) compared to capital employed to determine how efficiently a firm uses capital to generate earnings.
ROI compares the profits of an investment compared to the cost of the investment to determine gains.
Both measures are similar in theory, however, ROCE looks at how capital is employed within a firm and is useful when comparing companies within an industry. ROI looks purely at the profit made on an investment.
ROI = (PROFIT FROM INVESTMENT/COST OF INVESTMENT)*100
Unlike ROCE, ROI is a bit more flexible, as it can be used to compare products, but also projects and various investment opportunities. The downfall of ROI is that it doesn’t take the factor of time into account.
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