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Financial Ratio Analysis

Financial Ratio Analysis

admin / January 4, 2019

Calculations on financial ratios are basically derived from information obtained from the accounting records. The ratios provide the required guidelines of measuring the progress of the business and at the same time alert the management on the problems that might occur within the Company businesses.

The profitability ratios indicate the level of efficiency on how capital is being utilized. Liquidity ratios on the other hand help in indicating the ability of the Company to continue with its normal operations even in the midst of unexpected problems. While growth ratios are best used in the process of tracking down the financial progress of the Company (Graham, & Campbell, 2001, pp 187-243).

Compute the following ratios for 2009, and show supporting calculations (define each of the ratios, and explain them in simple terms

Current ratio

The current ratio is obtained through calculations derived from current assets and current liabilities. The ratio shows the relationship between current assets and current liabilities. The current assets refer to assets that are in form of cash or could easily be converted into cash within a short time.

While Current Liabilities, refer to liabilities that could be compensated or repaid within a short period of time. This ratio measures the company’s ability to settle short-term liabilities effectively and promptly (Graham, & Campbell, 2001, pp 187-243).

The ratio reveals the number of times the current assets could be used for the purposes of settling current liabilities. In normal circumstances the current assets should always be twice the current liabilities. However, any organization should have reasonable current ratio since higher ratio on this gives an indication of poor financial utilization. On the other hand, low ratio is an indication of insufficient working capital; hence the enterprise cannot settle its current liabilities (Keown et al, 1998).

Current Ratio = Current Assets/ current liabilities

= 220,000/80,000

= 3:1

The short term financial position of the company can be said to be satisfactory enabling the settling of current liabilities. But at the same time the ratio seem higher showing poor utilization of finances (Pink et al, 2007, pp 87-96).

Total assets to Debt ratio

This ratio compares the relationship between total assets and Long term debts. The total assets used under this calculation include fixed and current assets. This does not include fictitious assets which includes preliminary expenses, discount on share issue amongst others.

The Long term debts refers to debts that their maturity is considered due after a period of one year, these include; bonds, loans from banks and debentures. This ration is used by providers of long-term debts as measurement of safe bench mark for any business Institution.

The higher the ratio the better it means for the lenders based on the security involved in granting long-term loans to businesses. The lower the ratio the risky the business since it reveals that the business is heavily dependent on outside loans for survival. The ideal ratio for this calculation is normally 2:1 (Graham, & Campbell, 2001, pp 187-243).

Total Assets to Debt Ratio = Total Assets/Long Term Debts

= 1,000,000/300,000

= 3:1

The ratio is higher showing that the company’s security on loans is stable. This acts as assurance to lenders hence the company is capable of withstanding long-term loans.

Quick ratio

This shows the relationship between liquid assets and the current liabilities which is normally analyzed for the purposes of assessing the short-term liquidity of the company. Liquid assets refer to assets inform of cash or those that could be converted to cash in a short duration of time (Graham, & Campbell, 2001, pp 187-243).The calculations are as shown below;

Quick Ratio = Liquid assets /current Liabilities

Liquid assets = Current assets – (stock + Prepaid Expenses)

= 100,000/80,000

= 1:1

The Quick ratio of the company is satisfactory; this makes the company to be at stable position to meet its obligations.

Profit margin ratio

The profitability ratio indicates the ability of the company to plough back enough finances necessary for replacing the assets and also meet the increasing cases of services rendered to the company (Younis and Rice, 2001, pp 65-73)

Gross profit margin (%) = (gross income/ sales) ?100%

= (395,000/2,000,000) ?100%

= 19.75%

Net profit margin = (Net income/sales) ?100%

= (255,000/2,000,000) ?100%

= 12.75%

Both the gross profit and the Net profit margin are not satisfactory, showing that the company is not at a position which could enable it to frequently supply finances necessary to replace assets and increase the services required. The level of efficiency on how capital is being utilized is unsatisfactory.

References

Graham, J. R., & Campbell R. (2001). The Theory and Practice of Corporate

Finance: Evidence from the Field. Journal of Financial Economics, (60), 187-243.

Keown, A., J.W. Petty, D.F. Scott & Martin, J., (1998). Foundations of Finance. 2nd

Edition. London: Prentice Hall, Inc.

Pink, G., Imtiaz, D., McGillis, L. & Mckillop, I. (2007). Selection of Key

Financial Indicators: A literature, Panel and Survey Approach. Healthcare Quarterly Journal, (10), 87-96

Younis, B., & Rice, B. (2001). An empirical investigation of hospital profitability in The post- PPS era. Journal of Health Care Finance, (28), 65-73.

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