Calculate and discuss the importance of the following ratios: Liquidity Ratios —

Question

Calculate and discuss the importance of the following ratios:

Liquidity Ratios—working capital, current ratio, quick/acid-test ratio, receivable turnover, average day's sales uncollected, inventory turnover, average day's inventory on hand, operating cycle

Profitability Ratios—profit margin, asset turnover, return on assets, debt-to-equity ratio, return on equity

Long-term Solvency Ratios—debt-to-equity ratio, debt to total assets, times interest earned, cash debt coverage

Cash Flow Ratios—cash flow yield, cash flows to sales, cash flows to assets, free cash flow

Market Strength Ratios—Earnings per share, price-earnings per share, payout ratio, book value per share

Explanation / Answer

Liquidity Ratios

1. Working capital = Current assets – Current liabilities

It represents the short term health of the company. It indicates the capacity of the company to pay its current liabilities through current assets.

2. Current Ratio = Current assets / Current liabilities

Current ratio is same as working capital measured in terms of ratio. Current ratio more than 1 is considered as standard

3. Quick/Acid-test ratio = (Cash & Cash Equivalents + Marketable securities + Accounts Receivable) ÷ Current Liabilities

Quick ratio also shows the capacity of firm to pay its current liabilities but in a relatively short period of time. Only the assets which can be quickly converted to cash are considered for acid test ratio.

4. Receivable turnover ratio = Net sales / Average accounts receivables

This ratio indicates the number of times a firm is able to collect its receivables during a year. When converted to days its shows the average period firm takes to collect its credit sales.

5. Average day's sales uncollected = (Accounts receivables / Net sales) * 365

This ratio shows the period, as number of days, for which the account receivable of a firm remains uncollected.

6. Inventory Turnover = Sales / Inventory

Inventory turnover is a ratio showing how many times a company's inventory is sold and replaced over a period. The days in the period can then be divided by the inventory turnover formula to calculate the days it takes to sell the inventory on hand or "inventory turnover days.

7. Average day's inventory on hand = Number of days in period / Inventory turnover ratio

This ratio measures the number of days a company takes to sell its average balance of inventory. It is also an estimate of the number of days for which the average balance of inventory will be sufficient. Days' sales in inventory ratio is similar to inventory turnover ratio and both measure the efficiency of a business in managing its inventory

8. operating cycle = Days Inventory Outstanding + Days Sales Outstanding – Days payable outstanding

This shows provides the period a firm takes to convert its inventory into cash. It includes the time taken to sell the inventory and also to collect the cash from receivables.

PROFITABILITY RATIOS

1. Profit Margin = Net Income / Sales

This ratio indicates the amount of profit a firm Is able to make on each dollar of sales. It also shows the efficiency of the firm to generate the profit on it sales.

2 Asset turnover = Sales / Total assets

This ratio shows the firm’s capacity to use its assets in order to generate revenue. Higher ratio indicates the better performance of the firm.

3 Return on assets = Net Income / Total Assets

This ratio indicates the return generated by the firm on the assets used in the business.

4 Debt-to-equity ratio = Total debts / Shareholder’s equity

This shows the proportion of debts and equity used to finance the business.

5 Return on equity = Net income/ Shareholder’s equity

This ratio indicates the return generated by the firm by using the funds provided by the shareholders. Here shareholder’s equity does not include preferred stock.

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