# Financial Ratios

Essay by review  •  February 20, 2011  •  Book/Movie Report  •  1,802 Words (8 Pages)  •  1,086 Views

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Financial data by itself may not give the complete picture about a company's performance and financial well being. It is difficult to evaluate standalone numbers without comparing them to certain norms and standards. Ratios provide a set of standardised parameters which can be compared across companies. Ratios of a company can be evaluated against industry benchmarks to know the relative position of that company against its peers.

There are various types of ratios depending on the nature of analysis required. Some ratios measure the operational strengths of a company while others measure the financial strength, valuation etc of the company.

Profitability ratios

Gross profit to sales

This ratio presents the gross profit as a percentage of total operating revenues of the company. Gross profit is arrived at by deducting cost of sales from revenues in the case of manufacturing and trading companies. In the case of a service company, the costs incurred for rendering the services are deducted from revenues.The ratio gives the gross margin enjoyed by the products sold by the company and is an indicator of the pricing power the company enjoys. However, in the case of multi-product or diversified companies this ratio may not give a clear picture.

Operating profit to sales

The ratio presents the operating profits as a percentage of operating revenues. Operating profits are profits before interest and taxes. Thus, the operating margin gives an idea of the profits generated before interest and taxes.In addition to being a measure of the pricing power enjoyed by the company, the operating margin also gives a broad idea about the efficiency of the company as well.

Net profit to sales

The net profit margin is calculated by dividing the net income after taxes by operating revenues. The ratio is a measure of the profits per rupee of sales which accrue to shareholders after settling all external claims.

Return on assets

Also called return on investments, this ratio measures the net income before interest as a percentage of total assets. Interest expenses are added to the net income while calculating this ratio.

The ratio is an indicator of the efficiency in using the assets. If the return on assets is lower than the average cost of funds, then the company is not doing a good enough job in squeezing returns out of its assets.

Return on net worth

Also called return on shareholders' funds or return on equity, this ratio measures the returns generated by the company on funds provided by shareholders. The ratio is calculated as net income divided by shareholders' funds. Shareholders' funds include share capital, reserves and retained earnings belonging to the shareholders.

Return on capital employed

This ratio measures the returns generated on long term funds used by the company. Long term funds include shareholders' funds and long term debt raised by the company.

The ratio is calculated by dividing the earnings before interest and tax or EBIT by long term funds used. Long term funds used can also be calculated by deducting short term liabilities from total assets.

Earnings per share

Earnings per share or EPS is probably the most well known ratio among investors. The EPS is calculated by dividing net income by total number of shares. The ratio measures the earnings generated per share of the company.When the total number of shares used for the calculation includes the shares to be issued under outstanding warrants or convertible bonds, the ratio is called diluted EPS.

A variant of the ratio is Cash EPS, which is cash profits divided by the total number of shares.

Efficiency or activity ratios

Stocks turnover

The ratio gives the number of times stocks are turned over during an accounting period. It is calculated by dividing cost of goods sold with the average level of inventory.Any change in stocks turnover ratio should be interpreted only after considering all the factors. A decline in the ratio generally points to a slow down in sales. However, it could also be the case that the company increased the stock level to feed rising demand.

Debtors collection

This ratio measures the speed with which a company collects dues from its customers. In other words it measures the efficiency in working capital management. The ratio is calculated by dividing trade accounts receivable with average daily sales. Thus, its shows the average number of days for which sales invoices remains unpaid.A rising trend in this ratio could mean a slowdown in demand, rising competition or inefficiency of the company. When demand is slowing down or when there is more competition, companies would give extended credit periods to customers which would push up this ratio. The ratio could also show variations if the demand is seasonal.

Assets turnover

This ratio measures the ability of the company to utilise its assets fully. The ratio is calculated by dividing revenues by total assets.A low assets turnover ratio generally means that the company's assets are not put to efficient use. However, the ratio should be seen in relation to the nature of the business. Capital intensive businesses would have low assets turnover ratio as their investment in assets would be very high. On the other hand, trading companies would have very high ratio. This does not mean that the capital intensive businesses are inefficient and trading companies are highly efficient.

In general, manufacturing companies with higher profit margins would have low assets turnover ratio. Usually, higher margins result from use of highly skilled processes involving large investments in machinery.

Liquidity and leverage ratios

Interest coverage

Interest coverage ratio checks whether the company is earning enough profits to pay interests. It is measured as operating cash profits divided by interest costs for the period. Operating cash profits is also called earnings before interest, tax, depreciation and amortisation or EBITDA.

The higher the ratio, the healthier the situation is. The ratio is relevant only if the company has significant borrowings. For a company with low levels of debt, the ratio would always be high as long as it is profitable.

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