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Financial ratios interpretation

financial ratios interpretation

The Valuation ratios compare the company's stock price with either the profitability of the company or the company's overall value to get a sense of how cheap. Financial ratio analysis is the technique of comparing the relationship (or ratio) between two or more items of financial data from a company's financial. Liquidity, Activity, Leverage, Operating Performance, and Cash flow. Following are the formulas used to calculate key financial ratios: 6. Page 7. RIDZWAN NAZRI FOREX TRADING In addition to to enable Kerberos from the protected and understand how the key associated. It supports various server service and published by Kaleb. More valuable for account.

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When interpreting the quick ratio, care should be taken over the status of the bank overdraft. A company with a low quick ratio may actually have no problem in payingits amounts due if sufficient overall overdraft facilities areavailable. Inventory turnover period is defined as:.

An increasing number of days or a diminishing multiple impliesthat inventory is turning over less quickly which is regarded as a badsign as it may indicate:. Inventory days. Year-end inventory is normally used in the calculation ofinventory turnover. An average based on the average of year-start andyear-end inventories may be used to have a smoothing effect, althoughthis may dampen the effect of a major change in the period.

Inventory turnover ratios vary enormously with the nature of thebusiness. For large and complex items e. This is normally expressed as a number of days:. Increasing accounts receivables collection period is usually a badsign suggesting lack of proper credit control which may lead toirrecoverable debts. Falling receivables days is usually a good sign, though it could indicate that the company is suffering a cash shortage.

Receivables days. The trade receivables used may be a year-end figure or theaverage for the year. For many businesses total sales revenue can safely be used, becausecash sales will be insignificant. But cash-based businesses likesupermarkets make the substantial majority of their sales for cash, sothe receivables period should be calculated by reference to credit salesonly. The result should be compared with the stated credit policy.

This is usually expressed as:. Inmost sets of financial statements in practice and in examinations thefigure for purchases will not be available therefore cost of sales isnormally used as an approximation in the calculation of the accountspayable payment period. Preference share capital is usually counted as part of debt ratherthan equity since it carries the right to a fixed rate of dividend whichis payable before the ordinary shareholders have any right to adividend.

Not all companies are suitable for a highly-geared structure. Acompany must have two fundamental characteristics if it is to usegearing successfully. Loan stock interest must be paid whether or not profits areearned. A company with erratic profits may have insufficient funds in abad year with which to pay the interest.

This would result in theappointment of a receiver and possibly the liquidation of the company. A companywith most of its capital invested in fast depreciating assets orinventory subject to rapid changes in demand and price would not besuitable for high gearing.

These companies generally enjoy relatively stable profits andhave assets which are highly suitable for charging. Nonetheless, theseare industries that could be described as cyclical. Companies not suited to high gearing would include those in theextractive, and high-tech, industries where constant changes occur. These companies could experience erratic profits and would generallyhave inadequate assets to pledge as security.

Interest cover. A business must have a sufficient level of long-term capital tofinance its long-term investment in non-current assets. Part of theinvestment in current assets would usually be financed by relativelypermanent capital with the balance being provided by credit fromsuppliers and other short-term borrowings.

Suitability of finance is also a key factor. A major addition to non-current assets such as the construction of anew factory would not normally be financed on a long-term basis byoverdraft. Calculate the following ratios for Ocean Motors and briefly comment uponwhat they indicate:. Limitations of EPS. EPS is also used to calculate theprice earnings ratio which is dealt with below. This is the most widely referred to stock market ratio, alsocommonly described as an earnings multiple.

To give an extreme but simpleexample:. There has not been a significant amount of change in the investorratios over the two years but the following specific comments could bemade:. Test your understanding 1. Neville is a company that manufactures and retails office products. Their summarised financial statements for the years ended 30 June 20X4and 20X5 are given below:. The directors concluded that their revenue for the year ended 30June 20X4 fell below budget and introduced measures in the year end 30June 20X5 to improve the situation.

These included:. Prepare a report to the directors of Nevilleassessing the performance and position of the company in the year ended30 June 20X5 compared to the previous year and advise them on whether ornot you believe that their strategies have been successful. XX Subject: Performance of Neville. As requested I have analysed the financial statements of Nevillefor the year ended 30 June 20X5 compared to the previous year to assessthe performance and position of the entity and to determine whether thestrategies that you have implemented have been successful.

The ratiosthat I have calculated are in an appendix to this report. Itwould therefore appear that the strategy of cutting prices and extendingcredit facilities has attracted customers and generated an increase inrevenue. Despite this increase however, the profitability of the company hasworsened with both gross profit and operating profit being lower thanthe previous year.

Similarly the operating profit margin has declinedfrom There are likely to be several reasons behind thisdeterioration. The reduction in prices of goods will have contributed to theworsening gross profit. To rectify this, Neville may considerapproaching their suppliers for some bulk-buying discounts on the basisthat since they are selling more items they will be purchasing morematerial from suppliers.

The move of leasing additional machinery may also have contributedto the lower profitability. Assuming that the leases are being treatedas operating leases the lease payments will be being expensed to theincome statement. Given that non-current liabilities have decreased thisyear it would appear that the leases are being treated as operatingleases and not finance leases.

This is mainly due to the lower operating profit margins andreasons discussed above, as opposed to a decline in the efficient use ofassets since the asset utilisation has suffered only a slight fall. The revaluation of non-current assets will also have contributed tothe fall in the return on capital employed and would explain why theasset utilisation has fallen slightly.

The revaluation will have caused additional depreciation charges inthe income statement and thus is another factor in the worseningprofits. The increase in non-current assets is not fully explained by therevaluation. Hence it can be concluded that Neville have probablypurchased additional machinery as well as leasing to meet theincreased production needs.

These new machines may not have been fullyoperational in the current year and so would also explain the lowerreturns. The higher depreciation charges will also have contributed tolower profits. Receivables days have increased from an appropriate level of 65days to days. Represents the number of times inventory is sold and replaced. Take note that some authors use Sales in lieu of Cost of Sales in the above formula.

A high ratio indicates that the company is efficient in managing its inventories. Also known as "inventory turnover in days". It represents the number of days inventory sits in the warehouse. In other words, it measures the number of days from purchase of inventory to the sale of the same. Represents the number of times a company pays its accounts payable during a period.

A low ratio is favored because it is better to delay payments as much as possible so that the money can be used for more productive purposes. Also known as "accounts payable turnover in days" , "payment period". It measures the average number of days spent before paying obligations to suppliers. Measures the number of days a company makes 1 complete operating cycle, i. A shorter operating cycle means that the company generates sales and collects cash faster.

CCC measures how fast a company converts cash into more cash. It represents the number of days a company pays for purchases, sells them, and collects the amount due. Generally, like operating cycle, the shorter the CCC the better. Measures overall efficiency of a company in generating sales using its assets.

The formula is similar to ROA, except that net sales is used instead of net income. Measures the portion of company assets that is financed by debt obligations to third parties. Debt ratio can also be computed using the formula: 1 minus Equity Ratio. Determines the portion of total assets provided by equity i.

Equity ratio can also be computed using the formula: 1 minus Debt Ratio. The reciprocal of equity ratio is known as equity multiplier , which is equal to total assets divided by total equity. Evaluates the capital structure of a company.

Measures the number of times interest expense is converted to income, and if the company can pay its interest expense using the profits generated. EBIT is earnings before interest and taxes. EPS shows the rate of earnings per share of common stock.

Preferred dividends is deducted from net income to get the earnings available to common stockholders. Used to evaluate if a stock is over- or under-priced. Determines the portion of net income that is distributed to owners. Not all income is distributed since a significant portion is retained for the next year's operations. Measures the percentage of return through dividends when compared to the price paid for the stock. A high yield is attractive to investors who are after dividends rather than long-term capital appreciation.

Indicates the value of stock based on historical cost. The value of common shareholders' equity in the books of the company is divided by the average common shares outstanding. When computing for a ratio that involves an income statement item and a balance sheet item, we usually use the average for the balance sheet item.

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🔴 3 Minutes! Financial Ratios \u0026 Financial Ratio Analysis Explained \u0026 Financial Statement Analysis


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Therefore, for every dollar invested in the business the company made 20 cents. The higher the ROCE, the better it is for its stakeholders. Consequently, an increasing ROCE over time is a good sign. This is one of the most used ratios in finance. The formula for the ROE is:. Also, an increasing ROE is a good sign. It means that the shareholders are getting rewarded over time for their risky investments. This leads to more future investments by other shareholders and the appreciation of the stock.

In fact, the problem with this ratio lies in its denominator. For instance, the Net Income is produced through assets that the company bought. Assets can be acquired either through Equity Capital or Debt Liability. Consequently, when companies decide to finance their assets through Debt, usually revenue accelerates at a higher speed compared to interest expenses. That, in turn, generates an artificially high Return on Equity.

For such reason, it is important to use this ratio cautiously and in conjunction with other leverage ratios as well such as the Debt to Equity ratio. The solvency ratios also called leverage ratios help to assess the short and long-term capability of an organization to meet its obligations.

In fact, while the liquidity ratios help us to evaluate in the very short term the health of a business, the solvency ratios have a broader spectrum. Be reminded that the assets can be acquired either through debt or equity. The relationship between debt and equity tells us the capital structure of an organization. Until debt helps the organization to grow this leads to an optimal capital structure.

When, instead, the debt grows and interest expenses grow exponentially too much this can be a real problem. Consequently, the Solvency Ratios help us to answer questions such as: Is the company using an optimal capital structure? If not, is debt or equity the problem? If the debt is the problem, will the company be able to repay its contracted debt through its earnings? This ratio explains how much more significant is the debt in comparison to equity. This ratio can be expressed either as a number or a percentage.

The debt to equity ratio is also defined as the gearing ratio and measures the level of risk of an organization. Indeed, too much debt generates high-interest payments that slowly erode the earnings. When things go right, and the market is favorable companies can afford to have a higher level of leverage. However, when economic scenarios change such companies find themselves in financial distress.

Indeed, as soon as the revenues slow down, they are not able to repay their scheduled interest payments. Therefore, those companies will have to restructure their debt or face bankruptcy, as happened during the economic downturn to many businesses. Is it good or bad? Of course, a gearing ratio of 4 is very high. This means that if things go wrong for a few months, you will not be able to sustain the business operations.

Not all contracted debt is negative. Indeed, debt that allows you to pay fixed interest helps companies to find their optimal capital structure. Instead, any increase in interest payments may result in burdening indebtedness and consequently financial distress. If we go back to the coffee shop example, the debt to equity ratio of 4 is ok if all the other coffee shops in the neighborhood operate with the same level of risk. It can be that operating margins for the coffee shop are so high that they can handle the debt burden.

Imagine the opposite scenario, where all the coffee shops in the area operate with a leverage of 2. If the price of the raw materials skyrocket, you will have to raise the cost of the coffee cup. This, in turn, will slow down the revenues.

While many coffee shops in the neighborhood will be able to handle the situation, your coffee shop with a gearing of 4 will go bankrupt after a while. This ratio helps us to further investigate the debt burden a business carries. In the previous example, we saw how the leverage could lead to financial distress.

The interest coverage tells us if the earnings generated are enough to cover the interest expenses. Indeed the interest coverage formula is:. The EBIT earnings before interest and taxes has to be large enough to cover the interest expense.

A low ratio means that the company has too much debt and earnings are not enough to pay for its interest expense. A high ratio means instead the company is safe. Keep in mind that being too safe can be limiting as well. In fact, an organization that is not able to leverage on debt may miss many opportunities or become the target of larger corporations.

How do we compute the interest coverage ratio? Therefore you will get the EBIT. Take the EBIT and divide it by your interest expense. This implies that the EBIT is 1. Therefore the company generates just enough operating earnings to cover for its interest. However, it is very close to the critical level of 1. Below one the company is risky. Indeed, it may be short of liquidity and close to bankruptcy anytime soon.

The formula is:. How do we compute the debt to asset ratio? A ratio lower than 0. A ratio higher than 0. Of course, this ratio needs to be assessed against the ratio of comparable companies. Efficiency is the ability of a business to quickly turn its current assets into cash that can help the business grow. In fact, the way you manage the inventory accounts receivables, and accounts payables is critical to the short-term business operations. They assess if an organization is efficiently using its resources.

The primary efficiency ratios are:. These ratios are called turnover since they measure how fast current and non-current assets are turned over in cash. This ratio shows how the well the inventory level is managed and how many times inventory is sold during a period. The faster an organization can turn its inventory in sales, the more efficient and effective it is.

This ratio is expressed in number. How do we compute our inventory turnover ratio? Compute our CoGS. Compute our average inventory. This means that in one year time the inventory will be sold 5. How do we know how long it will take for the average inventory to be turned in sales?

Well, to compute the days it will take to turn the inventory in sales, compute the following formula:. Through this ratio, you know that every 67 days your inventory will be turned in sales. A high inventory ratio indicates a fast-moving inventory and a low one indicates a slow-moving inventory. Of course, a ratio of 5. However, this ratio needs to be compared within the same industry. This ratio measures how many times the accounts receivable can be turned in cash within one year.

Therefore, how many the company was able to collect the money owed by its customers. It is expressed in number, and the formula is:. The net credit sales are those that generate receivable from customers. Indeed, each time a customer buys goods, if the payment gets postponed at a later date, this event generates receivable on the balance sheet.

Therefore, the transaction will be recorded as revenue on the income statement and an account receivable on the balance sheet. How do we compute the accounts receivable turnover? Compute our nominator, the net credit sales. This is given by the gross credit sales minus the returned product. Compute the receivable turnover given by the net credit sales over the average inventory.

It means that the receivables were turned into cash 3. To know how many days it took to collect the money lumped in the receivable we will use the formula below:. The receivables were turned into cash in days. This is a good receivables level it means that you can collect money from your customers on average every days. When the receivable level is too low, usually companies turn their attention to the collection department and make sure they make the collection period as short as possible.

Indeed, this will give additional liquidity to the business. This ratio shows how many times the suppliers were paid off within one accounting cycle. This ratio is expressed in number, and the formula is:. The payable turnover ratio is the flip side of the receivable ratio. Therefore, each time purchase on credit is made, this will show as CoGS on the income statement and an account payable on the balance sheet. How do we compute the accounts payable turnover?

Compute the average payable. The supplier during the current year was paid 3. Keeping a high payable turnover is crucial to conduct business. Indeed, suppliers will assess whether or not to entertain business with an organization based on its capability to quickly repay for its obligations.

Valuation is a very tricky part of finance. Indeed, valuing a company means assessing how much that is worth. Valuing is so hard since the resources a company has been organized in a way for which it becomes challenging to determine the final value. In addition, we have the human capital aspect that is also very difficult to assess. For such reason, valuation can be considered more of an art than a science.

We are going to list the main valuation ratios here. Indeed, it is essential as well to know what are the main valuation ratios also to understand whether a company is over or undervalued. In other words, valuation ratios assess the perception of the market of a certain company. Quite the opposite; for instance, if we find a company that is doing extremely well regarding profitability, liquidity, leverage, and efficiency but Mr.

Market does not like it; it might be useful to understand why. If the reason stands behind things that Mr. On the other hand, if Mr. This ratio tells us what is the return for every single share. The formula is given by:. When the ratio is increasing over time it means that the company may represent a good investment for its shareholders although it must be weaved with other ratios before we can assess whether it is a good investment.

This ratio tells us how many times over its earnings the market is valuing the stock:. This ratio tells us how much of the stock value has been paid toward dividends. In other words, how much in percentage shareholders are getting back from their investment in stocks:. Indeed a higher Dividend Yield is a good sign, and it means that the company is rewarding its shareholders.

Also, stocks with historically high dividend yields have often been sought as good securities by stock market investors. But how do we assess whether the dividends yield is high enough? This ratio tells us whether a company is paying enough dividends to its shareholders, and its formula is:. The payout ratio must be assessed case by case on the one hand. On the other side, a meager payout ratio is less attractive for investors, who are looking for higher returns.

Those ratios help us to have an understanding of how Mr. Market values a business. On the other hand, we want to use valuation ratios in conjunction with liquidity, profitability, efficiency, and leverage. In other words, decide before to start your analysis beforehand what will be the ratios that will guide you throughout your analysis. It's a measure of how effectively a company uses shareholder equity to generate income.

You might consider a good ROE one that increases steadily over time. That could indicate a company does a good job using shareholder funds to increase profits. In turn, that can increase shareholder value. Fundamental analysis is the analysis of a security to discover its true or intrinsic value. It involves the study of economic, industry, and company information. Fundamental analysis can be useful because by comparing a security's true value to its market value, an investor can determine if the security is fairly priced, overvalued, or undervalued.

Fundamental analysis contrasts with technical analysis, which focuses on determining price action and uses different tools, such as chart patterns and price trends, to do so. That depends on what you're looking for in an investment. However, it could be low because the company isn't financially healthy. Financial ratios can help you pick the best stocks for your portfolio and build your wealth. Dozens of financial ratios are used in fundamental analysis.

We've briefly highlighted six of the most common and easiest to calculate. Remember that a company cannot be properly evaluated using one ratio in isolation. So be sure to put a variety of ratios to use for more confident investment decision-making. Financial Statements. Financial Ratios. Your Money. Personal Finance. Your Practice. Popular Courses. Table of Contents Expand. Table of Contents. Working Capital Ratio.

Quick Ratio. Earnings per Share EPS. Debt-to-Equity Ratio. Return on Equity ROE. Financial Ratio FAQs. The Bottom Line. Part of. How to Value a Company. Part Of. Introduction to Company Valuation. Fundamental Analysis Basics. Fundamental Analysis Tools and Methods. Valuing Non-Public Companies. Key Takeaways Fundamental analysis relies on data from corporate financial statements to compute various ratios.

Fundamental analysis is used to determine a security's intrinsic, or true, value so it can be compared with the security's market value. There are six basic ratios that are often used to pick stocks for investment portfolios. Most ratios are best used in combination with others, rather than singly, for a comprehensive picture of company financial health. When ratios are properly understood and applied, they can help improve your investing results.

What's a Good ROE? What Is Fundamental Analysis? Compare Accounts. The offers that appear in this table are from partnerships from which Investopedia receives compensation. This compensation may impact how and where listings appear. Investopedia does not include all offers available in the marketplace. Related Articles. Partner Links. The acid-test ratio is a strong indicator of whether a firm has sufficient short-term assets to cover its immediate liabilities.

What Is Working Capital Management?

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