Studying The Different Types Of Ratio Analysis Finance Essay - Free Essay Example

Sample details Pages: 5 Words: 1465 Downloads: 2 Date added: 2017/06/26 Category Finance Essay Type Research paper Did you like this example? Ratio Analysis is a technique used for financial analysis in which the figures are converted according to the ratios allotted for some useful assessment in comparison with the ratios of the past years and setting a bench-mark for the future years. This technique is very useful so as to establish the trends and bring in light, the strengths and weaknesses of the firm. The ratio analysis includes ratios that which are made up from the financial statements of the firm and includes key factors like profitability ratios, return on capital employed, liquidity ratios, working capital management ratios and capital structure ratios along with the stock market ratios. Don’t waste time! Our writers will create an original "Studying The Different Types Of Ratio Analysis Finance Essay" essay for you Create order The health of any company is clearly visible in the ratio analysis and gives the interpreter a clear picture when it is compared with the performances of previous years and other similar industry competitors. (Droms W.G., 2003) RELEVANCE OF RATIO ANALYSIS: Helps in assessing the firms performance: This technique is highly beneficial in assessing the financial health, profitability and operational efficiency of the firm. It ensures that the weaknesses of any firm will not go unnoticed as each and every fine detail is mentioned in the statements which will again be reflected in the ratios found out. Easiness of comparison within industry competitors: This technique is essential so as to compare the returns of the concerned firm with the industry standards and other leaders of the industry. Determination of financial health: This technique is used by the firm so as to know about the financial health of the firm in regards with the improvement or deterioration. It helps in setting out the direction of a companys action as the output is right out in front. Beneficial for budgeting and forecasting: The technique is used by the firm so as to know about the financial health of the firm in regards with the improvement or deterioration. It helps in setting out the direction of a companys action as the output is right out in front. Long Term Solvency: This technique is also widely used for its relevance in determining the financial health of the company down the line after few years due to various ratios like leverage ratios and capital structure ratios. (Steffy W., Zearley T., Strunk J., 2007) Weakness of ratio analysis: Many big companies operate in different business departments, thus it is difficult for them to compare against industry average. Inflation has played a key role in distorting the balance sheets as the written value is sometimes not even near to the original value, since the depreciation charges and cost of inventory is substantially affected by it. Different accounting practices being followed in the industry makes it more difficult for them to compare with other competitors. (Brigham E.F., Houston J.F., 2007) Profitability ratios: This ratio basically tells the analyst whether the business is making profit or is at some loss. It also lets the management know whether their strategy has been successful, if any related to the increase of profit margin. Gross Profit ratio: (Gross profit/sales)*100 % For 2008 = (62784.73/313923.68)*100 = 19.99 % For 2009 = (82404.96/494429.8)*100 = 16.66 % For 2010 = (102025.19/682784.01)*100 = 14.94 % Net Profit ratio: (Net profit/sales)*100 % For 2008 = (31392.36/313923.68)*100 = 9.99 % For 2009 = (43164.5/494429.8)*100 = 8.73 % For 2010 = (53454.35/682784.01)*100 = 7.83 % These ratios indicate the capacity of the company to generate profit or to control its business. The firm has seen the gross profit ratio and net profit ratio decline from 2008 to 2010. This has been primarily due to the fact that the firm has seen the sales figure increasing and not so great increment in profit share in it which might be possible due to the poor management of the funds or assets of the company. Share-holders ROCE: (Profit/Shareholders fund)*100% For 2008 = (31392.36/46215.25)*100 = 67.92 % For 2009 = (43164.5/92640.79)*100 = 46.59 % For 2010 = (53454.35/150838.46)*100 = 35.44 % Overall ROCE: (Profit/ (Shareholders fund + Borrowed Capital))*100 % For 2008 = (31392.36/46215.25)*100 = 67.92 % For 2009 = (43164.5/92640.79)*100 = 46.59 % For 2010 = (53454.35/ (150838.46 + 14822.87))*100 = 32.26 % The firm has been experiencing a drastic drop in the return on capital employed. This has happened primarily due to drop in the increasing rate of profit and huge increments in sales happening. Liquidity ratios: Liquidity imitates any firms ability to meet the short term obligations against the assets owned by the company which are readily convertible into cash. Current assets are mentioned as working capital as this is the capital which is used in day to day expenditure of the company. Current ratio: (Current assets/ Current liability) For 2008 = (44584.73/11561.84) = 3.86 For 2009 = (100200.45/21344.94) = 4.69 For 2010 = (180632.43/29942.21) = 6.03 This ratio indicates the capacity of the firm to pay off its debts within the time frame of a year with current assets in hand. The industry standard is considered to be 2:1. In our case, the company has been experiencing a sharp increase in this ratio. This has happened due to the fact that the company is keeping most of the money from the profits or sales in banks and are not investing it into the business. Quick ratio: ((Current assets stocks)/ Current liability) For 2008 = (40879.01/11561.84) = 3.53 For 2009 = (92789.01/21344.94) = 4.35 For 2010 = (165809.56/29942.21) = 5.54 This ratio emphasizes on the fact that not all assets are easily and instantly convertible into cash including the likes of stocks. In our firm, it has increase a sharp increase in the ratio from 2008 to 2010. This is also due to the same reason for keeping most of the cash in the bank and not investing it into business. Working Capital Management: This ratio basically emphasizes on how well the assets or services of the company are being utilised. This would gauge a firms capability to use the credit it receives from the market and in turn receive the investment from the debtors as quickly as possible. Stock Holding Period: (Average stocks/cost of sales)*365 For 2008 = (3705.72/251138.95)*365 = ~ 6 days For 2009 = (7411.44/412024.84)*365 = ~ 7 days For 2010 = (14822.87/580758.82)*365 = ~ 10 days This ratio tells the analyst about the time frame that the firm has to keep the stocks with them before they are sold into the market. This ratio is increasing from 6 to 10 days in the end which is not a matter of concern. Debtors Collection period: (Debtors/ Total Sales)*365 For 2008 = (7411.44/313923.68)*365 = ~ 9 days For 2009 = (15564.02/494429.8)*365 = ~ 12 days For 2010 = (35574.9/682784.01)*365 = ~ 20 days This ratio tells us the capability of the firm to collect money from its debtors as not all business transactions are done in cash. Here we see that the time frame has increased more than double for collection which is not a good sign and the company should follow up closely with the clients and put a bit of pressure on them in the permissible limit. Creditors payment period: (Creditors/cost of sales)*365 For 2008 = (8300.81/251138.95)*365 = ~ 13 days For 2009 = (16601.62/412024.84)*365 = ~ 15 days For 2010 = (24605.97/580758.82)*365 = ~ 16 days This ratio tells us the time frame that the company takes before handing out the payments back to the creditors. The time frame has been increasing from 2008 to 2010. This is a good sign as this means that the money which is handed out late to the client can help the firm in any investment for that period or to earn interest on it. Capital Structure ratios: Financing of a company is done either by equity or debt. Equity allows the directors of the company to decide at their own discretionary. But, debt financing involves an element of greater risk and an obligation to pay off the investment along with the interest to the concerned institution or investor. Gearing ratio: (Borrowed Capital/ (Shareholders fund + Borrowed capital))*100 For 2010 = (14822.87(14822.87 + 150838.46)) = 8.95 % This ratio is not applicable for 2008 and 2009 as the company was all financed by equity capital and was not using any borrowed capital or long term loan. But, in 2010, the firm borrowed capital from the market which is a good sign as it helps the company in reducing the taxes as the interest paid for loan is included after deduction of interest. Interest cover: (Net Profit/ Interest) For 2010 = (53454.35/ 1482.29) = 36 times Since the company had no borrowed money in 2008 and 2009, thus it was not entitled to pay any interest. But, after borrowing money in 2010, it was clearly visible that the company had more than enough funds to cover the interest to be given to the concerned institution or investor investing in the firm. Dividend Cover: (Net Profit/ Dividends) For 2008 = (31392.36/3261.03) = 9.62 times For 2009 = (43164.5/4743.32) = 9.1 times For 2010 = (53454.35/5336.24) = 10.02 times The company is in a strong position to pay out the dividends to its share holders which would further instil confidence in the investors to invest more. CONCLUSION: After analysing through the reports of the company and glancing through the ratios, we come to the conclusion that the company is in desperate need of proper management which can take suitable actions. These actions include primarily increasing the gearing ratio of the firm which looks very low. This would in-turn solve most of the problems by saving the money from going into the tax and diverting it as interest. Another key suggestion might be to decrease the money in the bank and invest it into the company, so that the company can experience greater growth rates and an increased opportunity for the investors as well. The firm should also keep a close eye on the debtors collection period ratio as the time has more than double within 3 years which is not a good sign.