Chapter 3 presents the concept of financial analysis through the use of ratios.
ID: 2817020 • Letter: C
Question
Chapter 3 presents the concept of financial analysis through the use of ratios. The chapter presents 13 ratios in four categories. Briefly explain the four categories and discuss why they would be important in making a stock purchase. In preparing your comments, assume you have $10,000 to invest in the stock market and you are trying to choose between companies in the same industry. How would you use the ratios presented in chapter 3 to decide what stock to purchase? Why would you take the time and effort to calculate the ratios instead of seeking investment advice from a market analyst?
Classification System
We will separate 13 significant ratios into four primary categories.
A. Profitability ratios
1.
Profit margin
2.
Return on assets (investment)
3. Return on equity
B. Asset utilization ratios
4.
Receivable turnover
5.
Average collection period
6.
Inventory turnover
7.
Fixed asset turnover
8.
Total asset turnover
C. Liquidity ratios
9. Current ratio
10. quick ratio
D. Debt utilization ratios
11. Debt to total assets
12. Times interest earned
13. Fixed charge coverage
Classification System
We will separate 13 significant ratios into four primary categories.
A. Profitability ratios
1.
Profit margin
2.
Return on assets (investment)
3. Return on equity
B. Asset utilization ratios
4.
Receivable turnover
5.
Average collection period
6.
Inventory turnover
7.
Fixed asset turnover
8.
Total asset turnover
C. Liquidity ratios
9. Current ratio
10. quick ratio
D. Debt utilization ratios
11. Debt to total assets
12. Times interest earned
13. Fixed charge coverage
Explanation / Answer
1. Profit margin: Profit margin measures the amount of each dollar of sales that a company has left over after its pays all its expenses. For instancem if a company has a profit margin of 20%, it means the company makes 20 cents of profit for each dollar of sales.
= Net profit / total sales
2. Return on Assets: is an indicator of how profitable a company is relative to its total assets. ROA gives an idea as to how efficient management is at using its assets to generate earnings.
= Net Profit / Total assets
3. Return on equity: ROE is the amount of net income returned as a percentage of shareholder's equity. ROE measures a company's profitability by revealing how much profit a company generates with the money shareholders have invested.
= Net income / shareholder's equity
4. Receivable turnover: The receivable turnover ratio measure how efficiently a firm uses its assets. Receivable turnover increase means a company is more effectively processing credit. In comparison, an accounts receivable turnover decrease means a company is seeing more delinquent clients.
= Total sales / average receivable
5. Average collection period: The average collection period indicates the average number of days elapsed between a credit sales and the date the company receives the payment from the credit sale.
= (Total receivable / total sales)* 365
6.Inventory turnover: shows how effectively inventory is managed by comparing goods sold with average inventory for a period. It measures how may times a company sold its total average inventory dollar amount during a period.
= Total sales / average inventory
7. Fixed asset turnover : indicates how well the business is using its fixed assets to generate sales. A declining ratio may indicate that the business is over-invested in plant, equipment, or other fixed assets.
= Total sales / average fixed assets
8. Total assets turnover : measures a company's ability to generate sales from its assets by comparing net sales with average total assets.
= Total sales / Average total assets
9. Current ratio: measures a company's ability to pay short term and long term obligations.
= Total current assets / total current liabilities
10. Quick ratio : indicates the company's short term liquidity and measures a company;s ability to meets its short term obligations with its most liquid assets.
Quick assets are tose assets which can easily be converted into cash. For eg. Cash, marketable securities, accounts receivable
= (Total current assets - inventory - prepaid expenses) / Total liabilities
11. Debt to total assets: shows how a company has grown and acquired its assets over time. It measures the company's assets that are financed by debt, rather than equity.
= Total Debt / Total assets
12. Times interest earned: measures a company's ability to meets its debt obligations. Failing to meet these obligations could force a company into bankrupcy.
= EBIT ( Earning before interest and taxes) / Interest
13. Fixed charge coverage ratio: measures a firm's ability to pay all of its fixed charges or expenses with its income before interest and income taxes.
= EBIT + Fixed charges before tax
Fixed charges before taxes + Interest
Importance of ratio analysis: Ratio analysis is a useful management tool that will improve your understanding of financial results and trends over time, and provide key indicators of organizational performance. Invetors use ratio analysis to pinpoint strengths and weaknesses of a company before investing in any stocks.
Most of the time, market analyst suggests about the stocks which are performing well or which are not performing well. Based on market sentiment, they advice which stocks will give better return in the coming time. But They don't provide the financial stength and weakness of those stocks. As an investor, who wants to invest in more than one stock choosing from multiple stocks, in that case these ratio analysis will help them to compare the financial strength of those stocks. These ratio analysis also helps to measure how the company is performing historically.
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