Financial Statement Analysis Magazine Section

Financial Statement Ratios Explained

Following are some Key Financial Statement Ratios explained:

LIQUIDITY RATIOS

CURRENT RATIO:

This ratio is obtained by dividing the 'Total Current Assets' of a company by its 'Total Current Liabilities'.

The ratio is regarded as a test of liquidity for a company. It expresses the 'working capital' relationship of current assets available to meet the company's current obligations. Therefore it is also known as the Working Capital.

When current assets equal current liabilities the ratio equals one. At this point the company has no working capital. A Current Ratio of over one means that the company has working capital. A ratio between 1.2 and 2 is deemed adequate. Anything over two can be argued as the company not being able to invest its excessive operational assets.

The formula:

Current Ratio = Total Current Assets/ Total Current Liabilities


QUICK RATIO:

This ratio is obtained by dividing the 'Total Quick Assets' of a company by its 'Total Current Liabilities'. Sometimes a company could be carrying heavy inventory as part of its current assets, which might be obsolete or slow moving. Thus eliminating inventory from current assets and then doing the liquidity test is measured by this ratio. The ratio is regarded as an acid test of liquidity for a company. It expresses the true 'working capital' relationship of its cash, accounts receivables, prepaids and notes receivables available to meet the company's current obligations.

The formula:

Quick Ratio = Total Quick Assets/ Total Current Liabilities

Quick Assets = Total Current Assets (minus) Inventory

 

EFFICIENCY RATIOS

DSO (DAYS SALES OUTSTANDING): The Days Sales Outstanding ratio shows both the average time it takes to turn the receivables into cash and the age, in terms of days, of a company's accounts receivable. The ratio is regarded as a test of Efficiency for a company. The effectiveness with which it converts its receivables into cash. This ratio is of particular importance to credit and collection associates.

Best Possible DSO yields insight into delinquencies since it uses only the current portion of receivables. As a measurement, the closer the regular DSO is to the Best Possible DSO, the closer the receivables are to the optimal level.

Best Possible DSO requires three pieces of information for calculation:

Current Receivables

Total credit sales for the period analyzed

The Number of days in the period analyzed

The formula:

Best Possible DSO = Current Receivables/Total Credit Sales X Number of Days

The formula:

Regular DSO = (Total Accounts Receivables/Total Credit Sales) x Number of Days in the period that is being analyzed


INVENTORY TURNOVER RATIO:

This ratio is obtained by dividing the 'Total Sales' of a company by its 'Total Inventory'. The ratio is regarded as a test of Efficiency and indicates the rapiditity with which the company is able to move its merchandise.

The formula:

Inventory Turnover Ratio = Net Sales / Inventory

The formula:

This ratio can also be calculated as: Inventory Turnover Ratio = Cost of Goods Sold / Inventory


ACCOUNTS PAYABLE TO SALES (%): This ratio is obtained by dividing the 'Accounts Payables' of a company by its 'Annual Net Sales'. This ratio gives you an indication as to how much of their suppliers money does this company use in order to fund its Sales. Higher the ratio means that the company is using its suppliers as a source of cheap financing. The working capital of such companies could be funded by their suppliers.

The formula:

Accounts Payables to Sales Ratio = [Accounts Payables / Net Sales ] x 100

 

PROFITABILITY RATIOS

RETURN ON SALES (PROFIT MARGIN) (%): The Profit Margin of a company determines its ability to withstand competition and adverse conditions like rising costs, falling prices or declining sales in the future. The ratio measures the percentage of profits earned per dollar of sales and thus is a measure of efficiency of the company.

The formula:

Return on Sales or Profit Margin = (Net Profit / Net Sales) x 100


RETURN ON EQUITY or NET WORTH (ROE): The Return on Equity (ROE) of a company measures the ability of the management of the company to generate adequate returns for the capital invested by the owners of a company. Generally a return of 10% would be desirable to provide dividents to owners and have funds for future growth of the company

The formula:

Return on Equity or Net Worth = (Net Profit / Net Worth or Owners Equity) x 100

Net Worth or Owners Equity = Total Assets (minus) Total Liability


RETURN ON ASSETS (ROA): The Return on Assets (ROA) of a company determines its ability to utitize the Assets employed in the company efficiently and effectively to earn a good return. The ratio measures the percentage of profits earned per dollar of Asset and thus is a measure of efficiency of the company in generating profits on its Assets.

Also deemed as Return on Investment or ROI

The formula:

Return on Assets = (Net Profit / Total Assets) x 100

 

INSOLVENCY RATIO

ALTMAN Z-SCORE: Using Multiple Discriminant Analysis Edward Altman combined a set of 5 financial ratios to come up with the Altman Z-Score. This score uses statistical techniques to predict a company's probability of failure using the following 8 variables from a company's financial statements:

For Z Score the following 8 inputs are essential: (Current Assets; Current Liabilities; Total Liabilities; EBIT; Total Assets; Net Sales; Retained Earnings; Market Value of Equity)

 

The 5 financial ratios in the Altman Z-Score and their respective weight factor is as follows:

 

 
RATIO
WEIGHTAGE
 
A
EBIT/Total Assets
x. 3.3
-4 to +8.0
B
Net Sales /Total Assets
x 0.999
-4 to +8.0
C
Market Value of Equity / Total Liabilities
x 0.6
-4 to +8.0
D
Working Capital/Total Assets
x 1.2
-4 to +8.0
E
Retained Earnings /Total Assets
x1.4
-4 to +8.0

These ratios are multiplied by the weightage as above, and the results are added together. 
Z-Score = A x 3.3 + B x 0.99 C x 0.6 + D x 1.2 + E x 1.4

The Interpretation of Z Score:

 

Z-SCORE ABOVE 3.0 -The company is safe based on these financial figures only.

Z-SCORE BETWEEN 2.7 and 2.99 - On Alert. This zone is an area where one should exercise caution.

Z-SCORE BETWEEN 1.8 and 2.7 - Good chances of the company going bankrupt within 2 years of operations from the date of financial figures given.

Z-SCORE BELOW 1.80- Probability of Financial embarrassment is very high.

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