Ratio Analysis

Ratio analysis is necessary to establish the relationship between two accounting figures to
highlight the significant information to the management or users who can analyze the
business situation and to monitor their performance in a meaningful way.

The following are the advantages of ratio analysis:

 It facilitates the accounting information to be summarized and simplified in a required

form.
 It highlights the inter-relationship between the facts and figures of various segments
of business.
 It provides necessary information to the management to take prompt decision relating
to business.
 Ratio analysis reveals profitable and unprofitable activities. Thus, the management is
able to concentrate on unprofitable activities and consider improving the efficiency.
 Ratio analysis is used as a measuring rod for effective control of performance of
business activities.
 Ratio analysis is an effective tool which is used for measuring the operating results of
the enterprises.
 Ratio analysis helps to determine the performance of liquidity, profitability and
solvency position of the business concern.

A.Profitability Ratio:

Profitability ratios are providing to as a percentage and in general the higher the profitability
percentage the better is the company’s performance. It is used to run the firm more
effectively as they used its available resources.

Profit margin

Net Income
Profit Margin = Sales
X 100 %

92500 52500
Jones = 1250000 x 100% Smith = 1000000 x 100%
=7.4 % =5.25%

The profit margin ratio compares profit to sales and tells you how well the company is
handling its finances overall. The profit margin is a ratio of a company's profit (sales minus
all expenses) divided by its revenue.

 In analyzing the profitability ratios, we see the Jones and Smith Corporation shows a
higher in Jones corp. 7.4% and lower in smith corp. 5.25%. Compare to the industry
average of 6.7 percent. Jones Corporation is in a good position and Smith is below
average to increasing the amount of profit made from the sale of a product.
Return on Asset (Investment)

Net Income
Return on Asset (Investment)= Total Asset X 100 %

92500 52500
Jones = 500000 x 100% Smith = 437500 x 100%

=18.5% =12 %

Return on equity is the measurement of shareholders wealth maximization. It indicates how

much shareholders earned from their investment.

 The Return on equity is higher in Jones Corp return shows 18.5% and the ratio
indicates the shareholders wealth maximization. So it’s good position of Jones Corp
that its present ROE is better than Smith Corp. However, its return on assets
(investment) of 18.5 % and 12 % and percent exceeds the industry norm of 10
percent.
 There is only one possible explanation for this occurrence more rapid turnover of
assets than that generally found within the industry.
 Thus the owners of Jones Corp are more amply rewarded than are other shareholders
in the industry. This may be the result of one or two factors: a high return on total
assets or generous utilization of debt or a combination thereof.

Net Income
Return on Equity= Total Asset X 100 %

92500 52500
Jones = 500000 x 100% Smith = 437500 x 100%

=28.9% =34.4 %

Return on Equity calculates the company’s profit generation against the money that was
invested by the shareholders. In the calculation above, ROE has the highest amount is come
in Smith Corp 34.4% and lowest amount is in Jones 28.9%. If the company can manage to
get better their profit levels, the ratio will much increase to a big amount better level.

B. Asset Utilization Ratios: The second category of ratios relates to asset utilization, and the
ratios in this category may explain why one firm can turn over its assets more rapidly than

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another. Notice that all of these ratios relate the balance sheet (assets) to the income statement
(sales).

Sales ( CREDIT )
Receivables Turnover = Receivables

1250000 1000000
Jones = 80000 Smith = 70000
=15.63x =14.29x

This Receivables Turnover ratio shows the number of times accounts receivables have been
turned into cash during the both corporations and collects its receivables faster than does the
industry.

 The ratio is intended to evaluate the ability of a company to efficiently issue credit to
its customers and collect funds from them in a timely manner. This is shown by the
receivables turnover of 15.63 and 14.29 times versus 10 times for the industry. This
ratio is good condition and range is satisfactory for both corporations.

Accounts Receivales
Average Collection Period = Avg . daily credit sales X 100 %

80000 70000
Jones = 1250000 x 100% Smith = 1000000 x 100%
= days = days

Sales
Inventory Turnover = Inventory

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 1250000 1000000
Jones = 50000 Smith = 75000
=25 times =13.3 times

Inventory turnover ratio measures how fast the inventory become cash or accounts
receivable. If the turnover number is more than the company’s position is good and vice
versa.

 Here we see the turnover is increasing and the firm turns over its inventory 25 times
and 13.3 times as contrasted with an industry average of 7 times. This tells us that
Jones and Smith generates more sales per dollar of inventory than the average
company in the industry, and we can assume the firm uses very efficient inventory-
ordering and cost-control methods It shows a positive impact on their management
efficiency but the speed is very slow .It should be more fast.

Sales
Fixed Asset Turnover = ¿ Asset

1250000 1000000
Jones = 500000 Smith = 500000
=3.57 times =4 times

Fixed Assets Turnover Ratio is used to measure the utilization of fixed assets. This ratio
establishes the relationship between cost of goods sold and total fixed assets.

 According to the ratio both firm maintains a slightly lower ratio of sales to fixed
assets (plant and equipment) than does the industry (3.57 times & 4 times versus 5.4)
as shown above. This is a relatively minor consideration in view of the rapid
movement of inventory and accounts receivable. This ratio is below average compare
to industry average and couldn’t proper utilize the fixed assets.

Sales
Total Asset Turnover = Total Asset

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 1250000 1000000
Jones = 500000 Smith = 437500
=2.29
=2.5

Asset turnover ratio measures the amount of sales a company generates on each Taka of
Fixed Assets. It indicated how efficiently the company utilizes its fixed assets to generate
sales. Investors use the asset turnover ratio to compare similar companies in the same sector
or group.

 Based on given ratio, Jones and Smith both shows good condition 2.5 and 2.29 times
compare to industry average 1.5 times.
 This ratio shows good condition industry average. As the ratio is higher than the
industry average so it can be said that Jones and Smith Corporation is supervision it’s
all assets effectively to generate sales.

B.LIQUIDITY RATIO:

Liquidity ratio is used to identify the company day to day activities.

Curr ent Asset

Current Ratio= Current Liabilities

Jones 150000
= 180000
= 1.5
Smith 187000
= 285000
= 2.5

Current Ratio is suitable for liquidity ratio that indicates how much time the current assets
face the current liabilities. It reflects whether the company is in a position to meet its
liabilities as the fall due.

 According to the result of the ratio of Jones and Smith shows that Smith corporation
had higher amount 2.5 times and Jones Corp has lower amount 1.5 times compare to
industry average. Smith Corp is a good sign for a firm. Because it proves that Smith

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 has ability to pay off its current liabilities with its current assets. It fact smith has the
higher current ratio is better for the organization as it helps to prevent getting default
and pay short term debt swiftly.

Current Asset−Inventories
Quick Ratio= Current Liabilities

Jones 150000−50000
= 180000
= 0.55

Smith 187500−75000
= 285000
= 0.39

The quick ratio represents the amount of short-term marketable assets available to cover

`short-term liabilities, and a good quick ratio is 1 or higher. The greater this number, the more
liquid assets a company has to cover its short-term obligations and debts.

 According to the ratio, Both Corporation indicate below average ratio .55 and 0.39
compare to industry average 1.0.Both corporation need to increase Sales & Inventory
Turnover and improving liquidity ratios is increasing sales, pay off liabilities as early
as possible. They should improve invoice collection Period and reducing the
collection period of A/R has a direct and positive impact on a company's quick ratio.

C. Debt utilization ratios

Total debt
Debt to Total Asset = Total Asset X 100 %

180000 285000
Jones = 500000 x 100% Smith = 437500 x 100%
=36% =65.1%

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The debt-to-total-assets ratio shows how much of a business is owned by creditors (people it
has borrowed money from) compared with how much of the company's assets are owned by
shareholders.

 As the ratio shows that Smith include high amount debt to total assets is 65.1% and
Jones has 36% which is lower than Jones. It is slightly above the industry average of
33 percent can issue new or additional shares to increase its cash flow. Jones and
smith both corporations in a well managed and good position by implementing
a debt/equity swap can make a debt holder an equity shareholder in the company.
The company can sell its assets and then lease them back.

Income before interest ∧taxes

Times Interest earned = Interest

193000 126000
Jones = 8000 Smith = 21000
=24.13 =6

Times interest earned indicates the number of times that income before interest and taxes
covers the interest obligation.  Times interest earned ratio is a measure of a company's ability
to meet its debt obligations based on its current income. 

 The ratio shows Jones corp. is higher the 24.13 times than smith 6 times which is
lower. Jones is the good position in the industry average and can interest-paying
ability of the firm.

Income before ¿ charges∧taxes ¿

Fixed charge coverage = ¿Charge

Income before fixed charges and taxes = Operating profit plus Lease
payments *
Fixed charges = Lease payments + Interest

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 193000+ 7000 126000+ 7000
Jones = 7000+ 8000 Smith = 7000+ 21000
=13.33 =4.75

The fixed-charge coverage ratio measures a firm's ability to cover its fixed charges, such as

debt payments, interest expense, and equipment lease expense. It shows how well a
company's earnings can cover its fixed expenses. Banks will often look at this ratio when
evaluating whether to lend money to a business.

 In the present case the Jones Corp has 13.33 times which are higher and good position
in industry average and compare to Smith Corp has lower amount 4.75 times. Jones
Corp more than compensates for a lower return on the sales dollar by a rapid turnover
of assets, principally inventory and receivables, and a wise use of debt. This ratio
measures the firm’s ability to meet all fixed obligations rather than interest payments
alone, on the assumption that failure to meet any financial obligation will endanger
the position of the firm.

Ratio Analysis Jones Smith Industry Conclusion

Corp. Corp Average

A. Profitability
 Profit margin 7.4% 5.25% 6.7%
 Return on Asset 18.5% 12.00% 10.0%

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  Return on Equity 28.9% 34.4% 15.0%

B. Asset Utilization Ratios

 Receivables Turnover 15.63 14.29 10.0

 Average collection period 23.04 25.2 36.0

 Inventory turnover 25. 13.3 7.0

 Fixed asset turnover 3.57 4 5.4

 Total asset turnover 2.5 2.29 1.5

C. Liquidity
 Current ratio 1.5 2.5 2.1
 Quick ratio 1.0 1.5 1.0

D. Debt Utilization
 Debt to total assets 36% 65.1 33.0%
 Times interest earned 24.13 6 7.0
 Fixed charge coverage 13.33 4.75 5.5

A. To which company would you, as credit manager for a supplier, approve

the extension of (short-term) trade credit? Why? Compute all ratios before
answering.

Since suppliers and short-term lenders are most concerned with liquidity ratios, Smith would
get the nod as having the best ratios in this category. One could argue, however, that Smith
had benefited from having its debt primarily long term rather than short term. Nevertheless, it
appears to have better liquidity ratios.

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B. Stockholders are most concerned with profitability. In this category, Jones has much better
ratios than Smith. Smith does have a higher return inequity than Jones, but this is due to its
much larger use of debt. Its return on equity is higher than Jones' because it has taken more
financial risk in terms of other ratios, Jones has its interest and fixed charges well covered
and in general its long-term ratios and outlook are better than Smith's. Jones has asset
utilization ratios equal to or better than Smith and its lower liquidity ratios could reflect better
short-term asset management, and that point was covered in part a.

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