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Ratio Analysis 1
Ratio Analysis 1
Ratio Analysis 1
This is one of the main form of assessing, analyzing and evaluating the performance of a business. It
is a study of the relationship of various elements of the financial statements (Trading and profit and
loss A/C & Balance Sheet). This analysis is vital in the decision making process by weighing the
options of investments or to plan for the future. However, since ratios are just ‘numbers’, the numbers
in isolation (on their own) are meaningless. That is, ratios are most useful when they are compared on
a year-to-year basis, with other companies of the same size and in the same industry. There is usually
a benchmark (standard ratio) which is acceptable, thus enable us to determine whether a ratio is high or
low.
USERS OF RATIOS
3. Bankers and Finance houses – To assess the credit worthiness and payback potential.
1. PROFITABILITY RATIOS : These ratios assess the performance of the business from a
profit perspective.
2. Liquidity Ratios: These ratios evaluate the level of liquidity in the business. It looks
at how well or how fast it is able to meet its current obligations, or
will it be able to cover its current liabilities in the short –run.
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3. Solvency Ratios: These are similar to liquidity ratios but takes an overall view of the
company’s potential to pay off its debts in the long run. That is, it
looks at the overall business and not just the current liabilities and
short-run but long-term liabilities and the long-run. It also looks at
how dependent the business is on outside sources of finance.
LIQUIDITY RATIOS:
This serves as a guide to see how well the company is able to cover its current liabilities, using its
current assets. A Benchmark of 2:1 is used as a guide to determine good or bad performance. Also
known as the working capital ratio but may be interpreted differently.
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This looks at the contribution of the net assets to net profit before interest and taxation is taken out
(deducted), a 25% ratio indicates that every $1 of net assets has contributed $0.25 of profit.
D) Earnings Per Share (EPS) = Profit after Tax and Preference Dividend. = $ #
Number of ordinary shares
This looks at how much is earned and available to pay as ordinary dividends for each
ordinary share.
SOLVENCY RATIOS
A) Interest Cover/Times Interest Earned Ratio = Profit before interest and Tax = #times
Interest Charges/Expense
This is a measure of how well the company is able to cover its interest expenses. It looks at how
many times the PBIT is able to cover interest expenses for the period. A year-to-year ratio will
indicate an increase/decrease in its ability to pay interest.
B) Gearing Ratio = Fixed cost capital(FCC) = Pref. Cap + Deb. + Mort. Etc. X 100% = #%
Total capital Ord. share cap + Res. + FCC
This tells how dependent the company is on outside sources of finance. A 50% ratio shows a
neutral position but lower indicate an ideal position while higher than 50% suggest too much
dependence on barrowing(too much liability).
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ACTIVITY RATIOS (OPERATIONAL EFFICIENCY RATIOS):
A) Stock Turn/ Turnover Ratio = Cost of Sales (Cost of goods sold) = # times
Average stock
This tells the number of times the company has sold out its stock and replenished it for the year.
The higher the turn over rate, the more prosperous the company is assumed to have been for the
period in question (year).