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# FINANCIAL RATIO ANALYSIS

## KEY BUSINESS RATIOS

1. Ratio Analysis ...................................................................................................................................... 3 2. Profitability Ratios ............................................................................................................................... 3 2.1 Return on Capital Employed (ROCE) ............................................................................................. 3 2.2 Return on Net Worth (RONW) ...................................................................................................... 3 2.3 Return on Assets (ROA) ................................................................................................................. 4 2.4 Net Profit Margin (NPM) ............................................................................................................... 4 3. Liquidity Ratios .................................................................................................................................... 5 3.1 Quick Ratio .................................................................................................................................... 5 3.2 Current Ratio ................................................................................................................................. 5 3.3 Current liabilities to Net worth Ratio ............................................................................................ 5 3.4 Total liabilities to Net worth Ratio ................................................................................................ 6 3.5 Fixed assets to Net worth Ratio .................................................................................................... 6 4. Efficiency ratios ................................................................................................................................... 7 4.1 Inventory turnover ........................................................................................................................ 7 4.2 Days sales of inventory (DSI) ......................................................................................................... 7 4.3 Asset turnover............................................................................................................................... 7 4.4 Working capital turnover ratio ..................................................................................................... 8 4.5 Debtors velocity ............................................................................................................................ 8 4.5 Creditors velocity .......................................................................................................................... 8 5. References .......................................................................................................................................... 9

1. Ratio Analysis
Ratio Analysis is a tool used by financial analysts to conduct a quantitative analysis of information in a company's financial statements. Generally, ratios are used in two ways: for internal analysis of items in a balance sheet; and/or for comparative analysis of a companys ratios at different time periods and in comparison to other firms in the same industry. Ratios can be classified into three groups: Liquidity Ratios Efficiency Ratios Profitability Ratios

2. Profitability Ratios
They are used to measure how well a company performs and analyze how profit was earned relative to sales, total assets and net worth.

## 2.1 Return on Capital Employed (ROCE)

Definition: It measures the returns that a company is realizing from its capital. Represents the efficiency with which capital is being used to generate revenue. ROCE should always be higher than the rate at which the company borrows funds, otherwise any increase in borrowing will reduce shareholders' earnings. A variation of this ratio is return on average capital employed (ROACE), which takes the average of opening and closing capital employed for the time period. Formula: ROCE =

## 2.2 Return on Net Worth (RONW)

Definition: It measures the rate of return on the ownership interest (shareholders equity) of the common stock owners. It shows how well a company is using investment funds to generate earnings growth. Also called Return on Equity (ROE)

Formula: RONW =

## Net Income____ Shareholders equity

Net income is for the full fiscal year (before dividends paid to common stock holders but after dividends to preferred stock.) Shareholder's equity does not include preferred shares.

## 2.3 Return on Assets (ROA)

Definition: It measures how profitable a company is relative to its total assets. It indicates how efficient management is at using its assets to generate earnings. Highly dependent on industry Formula: ROA =

## _Net Income_ Total Assets

Some financial analysts calculate it as ROA = Net Income + Interest Expense Interest Tax Savings Total Assets In this case, it measures how profitable a company is before leverage.

## 2.4 Net Profit Margin (NPM)

Definition: Basic measure of the firms profitability. Indicator of the companys pricing policies and its ability to cut costs. Formula: NPM =

## _Net Profit after tax_ Revenue

3. Liquidity Ratios
They are used to measure the financial soundness of a business and how well the company can satisfy its short- and long obligations. They are also called solvency ratios.

## 3.1 Quick Ratio

Definition: It measures the ability of a company to use its near cash or quick assets to immediately extinguish or retire its current liabilities. Quick assets include those current assets that presumably can be quickly converted to cash at close to their book values. Also called Liquid ratio or Acid Test ratio It should generally be 1:1 or better, however this varies widely by industry Formula: Quick ratio = Cash + Marketable securities + Accounts receivable Current Liabilities

## 3.2 Current Ratio

Definition: It measures the ability of a company to pay its debts over the next 12 months. Similar to Quick ratio, except that quick ratio does not include inventory and prepaids as assets that can be liquidated. It should generally be 2:1 or better, however this varies widely by industry Formula: Current ratio =

## 3.3 Current liabilities to Net worth Ratio

Definition: It indicates the amount due creditors within a year as a percentage of the owners' or stockholders' investment. It measures the funds creditors are risking with a business temporarily against the funds permanently invested by its owners. Normally a business starts to have trouble when this relationship exceeds 80%.

## 3.4 Total liabilities to Net worth Ratio

Definition: It shows how all of the companys debt relates to the equity of the owner or stockholders. The higher this ratio, the less protection there is for creditors. If total liabilities exceed net worth then creditors have more at stake than stockbrokers. The difference between this ratio and Current Liabilities to New Worth Ratio is that it pinpoints the relative size of long-term debt, which can burden a firm with substantial interest charges. Formula: Total Liabilities Net worth

## 3.5 Fixed assets to Net worth Ratio

Definition: It shows the percentage of assets centered in fixed assets compared to total equity. Generally the higher this percentage is over 75%, the more vulnerable a concern becomes to unexpected hazards and business climate changes. Capital is frozen in the form of machinery and the margin for operating funds becomes too narrow to support day-to-day operations. Formula: Fixed Assets Net worth

4. Efficiency ratios
They measure the quality of the firms receivables and how efficiently it uses and controls its assets, how effectively the firm is paying suppliers, and whether the firm is overtrading or undertrading on its equity (using borrowed funds).

## 4.1 Inventory turnover

Definition: It measures how fast inventory is moving the cash flow into the business. When this ratio is high, it may indicate a situation where sales are being lost because a concern is understocked and/or customers are buying elsewhere. If the ratio is too low, this may show that inventories are obsolete or stagnant. Formula: Inventory turnover =

## 4.2 Days sales of inventory (DSI)

Definition: It measures how long it takes a company to turn its inventory (including goods that are work in progress, if applicable) into sales. Generally, the lower (shorter) the DSI the better, but it is important to note that the average DSI varies from one industry to another. Formula: DSI =

## 4.3 Asset turnover

Definition: It measures the efficiency of a company's use of its assets in generating sales revenue. If percentage is low, it indicates that a business is not being aggressive enough in its sales efforts, or that its assets are not being fully utilized. A very high ratio may indicate a business is selling more than can be safely covered by its assets. Formula: Asset turnover =

## 4.4 Working capital turnover ratio

Definition: It measures the number of times working capital turns over annually in relation to net sales. A high turnover rate can indicate overtrading (excessive sales volume in relation to the investment in the business). A high turnover rate may indicate that the business relies extensively upon credit granted by suppliers or the bank as a substitute for an adequate margin of operating funds.

## 4.5 Debtors velocity

Definition: Also called collection period ratio or debtors turnover ratio. Helpful in analyzing the collectibility of accounts receivable, or how fast a business can increase its cash supply. Low values indicate better working capital management

## 4.5 Creditors velocity

Definition: Also called payment period ratio or creditors turnover ratio. It indicates how the company pays its suppliers in relation to the sales volume transacted. High values indicate better working capital management. However, extremely high values are not healthy as they indicate that the firm may be using suppliers to help finance operations.

## Accounts payable * 365__ Sales

5. References
www.dnb.com/product/contract/ratiosP.htm www.investopedia.com www.wikipedia.com