17 Feb Financial Ratios- Analyzing a Company’s Strengths and Weaknesses

Over the period of time, investors, Finance Managers and analysts have developed numerous analytical tools, concepts and techniques to compare strengths and weaknesses of companies. One of these tools is Ratio analysis which in Indian context mainly used by the bankers while funding for the project.

Ratio analysis is a tool that was developed to perform quantitative analysis on numbers found on financial statements. Ratios help link the three financial statements together and offer figures that are comparable between companies and across industries and sectors.

However, ratios vary across different industries and sectors and comparisons between completely different types of companies are often not valid.

Some of the most commonly used ratios are

1. Current ratio
2. Quick ratio
3. Inventory turnover
4. Asset turnover
5. Debt-to-equity ratio
6. Interest coverage ratio
7. Return on assets& Return on Equity
8. Current Ratio

The current ratio measures a company’s current assets against its current liabilities. The current ratio indicates if the company can pay off its short-term liabilities in an emergency by liquidating its current assets. Current assets are found at the top of the balance sheet and include line items such as cash and cash equivalents, accounts receivable and inventory, among others.

A low current ratio indicates that a firm may have a hard time paying their current liabilities in the short run and deserves further investigation. A ratio of 1.33x will be balanced ratio.

2. Quick Ratio

The quick ratio is a liquidity ratio that is more stringent than the current ratio. This ratio compares the cash, short-term marketable securities and accounts receivable to current liabilities. The thought behind the quick ratio is that certain line items, such as prepaid expenses, have already been paid out for future use and cannot be quickly and easily converted back to cash for liquidity purposes.

As stock in hand is out in this ratio company can manage its stock by comparing the ratios. This should be 1.00x

3. Inventory Turnover ratio

Inventory turnover is calculated by dividing cost of goods sold by average inventory. A higher turnover than the industry average means that inventory is sold at a faster rate, signaling inventory management effectiveness. Additionally, a high inventory turnover rate means less company resources are tied up in inventory. However, there are usually two sides to the story of any ratio. An unusually high inventory turnover rate can be a sign that a company’s inventory is too lean, and the firm may be unable to keep up with any increased demand. Furthermore, inventory turnover is very industry-specific. In an industry where inventory gets stale quickly, you should seek out companies with high inventory turnover.

4. Asset Turnover

Asset turnover measures how efficiently a company uses its total assets to generate revenues. The formula to calculate this ratio is simply net revenues divided by average total assets. A low asset turnover ratio may mean that the firm is inefficient in its use of its assets or that it is operating in a capital-intensive environment.

5. Debt-to-equity ratio

The debt-to-equity ratio measures the amount of debt capital a firm uses compared to the amount of equity capital it uses. A ratio of 1.00x indicates that the firm uses the same amount of debt as equity and means that creditors have claim to all assets, leaving nothing for shareholders in the event of a theoretical liquidation.

6. Interest coverage ratio

The interest coverage ratio, also known as times interest earned, measures a company’s cash flows generated compared to its interest payments. The ratio is calculated by dividing EBIT (earnings before interest and taxes) by interest payments.

7. Return on assets & Return on Equity

Two other profitability ratios are also widely used—return on assets(ROA) and return on equity (ROE). Return on assets is calculated as net income divided by total assets. It is a measure of how efficiently a firm utilizes its assets. A high ratio means that the company is able to efficiently generate earnings using its assets.

Return on equity measures net income less preferred dividends against total stockholder’s equity. This ratio measures the level of income attributed to shareholders against the investment that shareholders put into the firm. It takes into account the amount of debt, or financial leverage, a firm uses.

 

(This article is contributed by Ankur Kapil, Chartered Accountant in Practice and can be reached at ankurkapilca@gmail.com)