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Meaning of Ratio Analysis

A tool used to conduct a quantitative analysis of information in a company's financial statements. Ratios are calculated from current year numbers and are then compared to previous years, other companies, the industry, or even the economy to judge the performance of the company.

Uses of accounting ratios

Enable comparison of the performance of the company - in different years - with its budgets and forecasts - with other companies in similar trades

Uses of accounting ratios

Provide information of the company in respect of the liquidity, profitability, use of assets and capital structure Eliminate the effects of the scale and size of different companies or different years of the same company so comparison can be provided. Appraise the performance of the company, make predictions for future performance and assist in future planning

Accounting ratios and interpretation

Liquidity - current ratio / working capital ratio - acid test ratio / quick ratio / liquid ratio - stock turnover rate - stock turnover period - debtors collection period - creditors payment period

Liquidity is a measure of the amount of funds a company can quickly use to settle its debts.

Liquidity current ratio

This ratio indicates the ability of a business to meet its short-term liabilities from its current assets. Formula Current assets/Current liabilities The norm is 2:1. If the ratio is too high, the company may be holding too many idle short-term assets. (They may be used in a more profitable way.) If the ratio is too low, the company may not have sufficient funds to meet its short-term liabilities.

Liquidity acid test ratio

This ratio indicates the ability of the business to meet its short-term liabilities from its quick assets. Formula- Quick Assets/Current Liabilities The norm is 1:1. If the ratio is too high, the company may be holding excessive liquid assets. If the ratio is too low, the company may have a liquidity problem / cash flow problem.

Liquidity stock turnover rate

It shows the number of times that a business can sell its average stock in a period. Formula COGS/Average Stock A high ratio means high sales, fast stock turnover and a low stock level. A low ratio means low sales, low stock turnover and a high stock level. (goods may become obsolete, high storage cost)

Liquidity debtors collection period

This ratio measures the debt collection period of a business. Formula Credit Sales/Average Debtors A low ratio means debtors pay back their debts in a short period of time. The company may have sufficient liquid fund. A high ratio indicates a poor credit control and a high risk of bad debts.

Liquidity creditors payment period

This shows the length of time taken to pay the creditors. Formula Credit Purchases/Average Creditors A long payment period may indicate that the company has a liquidity problem. The relationship between the company and the suppliers may be affected.

Examples of interested group

Liquidity - shareholders - suppliers - creditors - competitors


Limitations of ratio analysis

Different definitions of capital employed may cause confusion. Changes in price level will affect the comparability of the ratios between two financial periods. Changes in external environment will affect the comparison.

Limitations of ratio analysis

Differences in management and background of various businesses may affect the comparison. Different accounting definitions, methods, techniques and policies used by various businesses may affect the comparability. It is difficult to set up a proper standard for good performance. Short term fluctuations may not be reflected.

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