Basic Financial Ratio Analysis
Reading this review of financial ratio analysis you will realize that financial analysis is very important business tools to managers, boards, banks, payers, and others who make review about the financial health of business organizations. One generally accepted method of review of financial statements is ratio analysis, which uses data from the balance sheet and income statement to supply values that have easily interpreted financial meaning. Most businesses, banks, financial organizations, government organizations and others very often evaluate their financial health by calculating various ratios and comparing the values to those for previous periods, looking for some differences that could indicate a significant change in financial condition and financial health. Financial analysis must select relevant information, analyze it and interpret the analysis to see current and future financial health and condition and any review of financial ratio analysis would be incorrect without that.
Ratio is mathematical relation between two quantities. Financial ratio is comparison between two financial values or information. We can classify financial ratios as a return ratio, turnover ratios, coverage ratio, or a component percentage. But there are six aspects of a financial health and condition that we can evaluate from financial ratios:
1. Liquidity ratio, this ratio can provide information about business ability to meet its obligations
2. Profitability ratio, this ratio provides information about how many dollars are coming into the company from every sale
3. Activity ratio, provides information about company ability to manage their resources
4. A financial leverage ratio provides information about companys fixed financing obligations
5. Shareholder ratio provides information about amount of profit per share of stock
6. Return of investment ratio provides information about amount of profit relative to the assets which were used to produce that profit
Liquidity ratio, as we said, shows us the level of liquidity some business needs for operating cycle, or this ratio can provide us information about some companys ability to generate cash to meet their needs. There are three generally accepted liquidity ratios:
1. Current ratio indicates business ability to satisfy its current obligations with its current assets
Current ratio=Current assets/Current liabilities
2. Quick ratio is the ratio that compares quick assets (current assent minus inventory) and current liabilities. It indicates business ability to satisfy current liabilities with liquid assets
Quick ratio= (Current assets inventory)/Current liabilities
3. Net working capital to sales ratio is the ratio that is comparing net working capital (current assets minus current liabilities) to sales
Net working capital to sales ratio= (current assets current liabilities)/sales
Generally speaking, the larger liquidity ratio is better.
Profitability ratios are comparing some components of cash income with sales. There are also three generally accepted profitability ratios:
1. Gross profit margin is the ratio that is comparing gross income to sales.
Gross profit margin= Gross income/Sales
2. Operating profit margin is the ratio that is comparing operating profit or E.B.I.T to sales
Operating profit margin= operating income/Sales
3. Net profit margin is the ratio of net income to sales
Net profit margin= Net income/Sales
Activity ratios are measuring how well assets are used. These ratios can be used to evaluate benefits produced by all companys assets. The bigger the turnover, the more effectively the company is producing benefits from its assets.
1. Inventory turnover is ratio that compares cost of goods that are sold to inventory. This ratio is showing us how many times inventory is created and sold during some period
Inventory turnover= Cost of goods sold/inventory
2. Accounts receivable turnover is the ratio of net credit sales to accounts receivable. This ratio is showing as how many times in the one period credit sales have been created.
Accounts receivable turnover= Sales on credit/Accounts receivable
3. Total asset turnover is ratio of sales to complete or total assets. This ratio is showing us the extent that the investment in total assets results in sales
Total asset turnover= Sales/Total assets
4. Fixed asset turnover is the ratio of sales to fixed assets. This ratio shows the ability of the company management to put fixed assets to work and generate sales
Fixed asset turnover= Sales/Fixed assets
Financial leverage ratios
The financial leverage ratio indicates to us the level to which the business relies on financial debt. These ratios are comparing the amount of debt to total capital of some business or to the equity capital.
1. Total debt to assets ratio are showing us the proportion of assets that are financed by debt
Total debt to assets= Total debt/total assets
2. Long term debt to assets ratio are showing us the proportion of the business assets financed by long term debt
Long term debt to assets ratio= Long term debt/total assets
3. Debt to equity ratio indicates to us the usage of debt and equity as sources for financing business assets
Debt to equity ratio= Total debt/Total shareholders equity
Shareholders are the owners of companies, and they can be directors and/or employees. A prime request of every shareholder is his return on investment. From this aspect, we can provide two ratios that are showing to us interests of the shareholders:
Interests per share or EPS is the ratio that is comparing a period per share of common stock
Interests per share= Net income available to shareholders/Number of shares outstanding
The EPS ratio is only useful when compared with previous years.
Price earnings ratio is the ratio of the price per share to the earning per share of common stock
Price earnings ratio= Market price per share/earnings per share
High price earnings ratio suggests to investors higher earnings growth in the future compared to companies with lower earnings.
Dividend per share is the total sum of dividends paid out over an entire year divided by the number of outstanding ordinary shares issued.
Dividends per share= Dividends paid to shareholders/Numbers of share out standings
By dividing the profit that is potentially available for allocation as dividend by the number of shares, we get a figure of earnings per share. This can be used as a criterion of the company’s profit result over time. It also shows the maximum potential for paying out a dividend to shareholders and how much each share has brings profit for its owner.
Thinking about how to conclude a review of financial ratio analysis, all I can think of is a little advice educate yourselves about shares, ratios, debts and other financial notions if you want your business to succeed.