This is the process of identifying the financial
strength and weakness of a company by properly establishing relationship
between items of the balance sheet and the profit and loss account. Finance
helps to establish the liquidity, the solvency, the efficiency and the
profitability of a company.
strength and weakness of a company by properly establishing relationship
between items of the balance sheet and the profit and loss account. Finance
helps to establish the liquidity, the solvency, the efficiency and the
profitability of a company.
Financial ratio
This is a powerful tune of finance. They are
designed to show relationship between terms in the financial statements. They
put numbers into perspective in case the data reported in the financial
position of the firm. Accounting figures contains meaning only when they are
related to other relevant information
designed to show relationship between terms in the financial statements. They
put numbers into perspective in case the data reported in the financial
position of the firm. Accounting figures contains meaning only when they are
related to other relevant information
Ratio analysis helps the analysis to make
qualitative statement such as : company xyz is liquid, company A is more
profitable than company B etc
qualitative statement such as : company xyz is liquid, company A is more
profitable than company B etc
Types of financial Ratios
In analyzing the financial statement, the analysis
must consider five basic ratios, which are:
must consider five basic ratios, which are:
1.
The liquidity ratios
The liquidity ratios
2.
The activity or efficiency ratio
The activity or efficiency ratio
3.
The leverage or solvency ratio
The leverage or solvency ratio
4.
The profitability ratio
The profitability ratio
5.
The market value ratio
The market value ratio
An indebt
analysis of the above ratio will assist the analysis in identifying
analysis of the above ratio will assist the analysis in identifying
1.
The opportunity available in the company
The opportunity available in the company
2.
The strength of the company
The strength of the company
3.
The weakness & threat of the company
The weakness & threat of the company
Liquidity
ratio
ratio
This
ratio measures the ability of the firm in meeting its current maturing
obligation. Although full liquidity analysis required preparation of budget and
cash flow statement. However, by relating the liquid assets to the current
obligation ratio analysis provides a quick & easy means of measuring the
liquidity of the company. The commonly used liquidity ratios are
ratio measures the ability of the firm in meeting its current maturing
obligation. Although full liquidity analysis required preparation of budget and
cash flow statement. However, by relating the liquid assets to the current
obligation ratio analysis provides a quick & easy means of measuring the
liquidity of the company. The commonly used liquidity ratios are
a.
Current ratio: these ratios relate current assets (i.e. asset that can
be easily converted to cash) to current liabilities. If a company is getting
into financial difficulty, it will start paying its debt slowly, starting
rescheduling its depts., start building bank loans etc. If these current liabilities
rise faster than current assets the current ratio will fall
Current ratio: these ratios relate current assets (i.e. asset that can
be easily converted to cash) to current liabilities. If a company is getting
into financial difficulty, it will start paying its debt slowly, starting
rescheduling its depts., start building bank loans etc. If these current liabilities
rise faster than current assets the current ratio will fall
Current ratio = CA/CL
As a convention rule, a current ratio of 2:1 above
is considered adequate
is considered adequate
b.
Quick or acid test ration: this establishes relationship between quick
or relatively liquid assets and current liabilities. An asset is relatively
liquid if it can convert into cash immediately or reasonably soon without any
loss of value. To this end stocks and prepaid expenses are considered liquid.
The liquid assets therefore are cash. Bank balance, debtors and highly
marketable short term securities
Quick or acid test ration: this establishes relationship between quick
or relatively liquid assets and current liabilities. An asset is relatively
liquid if it can convert into cash immediately or reasonably soon without any
loss of value. To this end stocks and prepaid expenses are considered liquid.
The liquid assets therefore are cash. Bank balance, debtors and highly
marketable short term securities
Or = (CA – Stock – PE) / CL
As a
conventional rule, a quick ratio of 1:1 above is considered adequate
conventional rule, a quick ratio of 1:1 above is considered adequate
Note:
In this analysis of liquidity ratio attention must be paid to the quality of
the current assets such as stocks, debtors, and bank balance
In this analysis of liquidity ratio attention must be paid to the quality of
the current assets such as stocks, debtors, and bank balance
c. Net working capital: this is an absolute measure of
liquidity. It shows by how much current assets exceed current liabilities
liquidity. It shows by how much current assets exceed current liabilities
Net working capital = CA – CL
Activity
& Efficiency ratio
& Efficiency ratio
Activity
ratio attempts to measure how efficiently a firm is managing its assets.
Efficiency here is measured by the rate at which the firm generate sale from
the application of this asset. This ratio arte called turnover ratio. Thus,high
turnover implies good assets management and vice versa. The various types of
efficiency ratio are:
ratio attempts to measure how efficiently a firm is managing its assets.
Efficiency here is measured by the rate at which the firm generate sale from
the application of this asset. This ratio arte called turnover ratio. Thus,high
turnover implies good assets management and vice versa. The various types of
efficiency ratio are:
1.
Total asset turnover (TAT) these measures the utilization of total
assets in generating sale. It indicates the sales generated by per naira of
total tangible assets. it is calculated as
Total asset turnover (TAT) these measures the utilization of total
assets in generating sale. It indicates the sales generated by per naira of
total tangible assets. it is calculated as
TAT = Net Sales/ tangible assets (NFA + CA)
The higher this ratio the better for
the firm vice versa
the firm vice versa
Fixed
asset turnover
asset turnover
This
measures the efficiency of the firm in the management of its fixed assets. it
is calculated as
measures the efficiency of the firm in the management of its fixed assets. it
is calculated as
FAT = Net Sales / Net
Fixed Assets
Fixed Assets
NFA = FA – Accumulated depreciation
The
higher this ratio, the better for the firm & vice versa
higher this ratio, the better for the firm & vice versa
Inventory/
turnover:
turnover:
This
shows how efficiently the firm’s inventory is being managed. That is, it shoes
the quality of the rough measure of how many a time per year the inventory
level is replaced i.e. the higher the inventory turnover the more marketable,
the firm inventory is and the better the firm. This measures the number of days
it takes the firm to sell its inventory. The shorter this is the better vice –
versa it is calculated as:
shows how efficiently the firm’s inventory is being managed. That is, it shoes
the quality of the rough measure of how many a time per year the inventory
level is replaced i.e. the higher the inventory turnover the more marketable,
the firm inventory is and the better the firm. This measures the number of days
it takes the firm to sell its inventory. The shorter this is the better vice –
versa it is calculated as:
Inventory
turnover = (cost of goods sold)/ (average – inventory)
turnover = (cost of goods sold)/ (average – inventory)
Where:
CGS
= Opening stock + Purchase – Closing Stock
= Opening stock + Purchase – Closing Stock
Average
Inventory = (Opening Stock + Closing stock) / 2
Inventory = (Opening Stock + Closing stock) / 2
Or
Net
Sales/ closing Stock
Sales/ closing Stock
Days
in Inventory = (Average Stock x 365)/(cost of gloss sold)
in Inventory = (Average Stock x 365)/(cost of gloss sold)
Average
collection period
collection period
This
measures how efficient the firm is in collection of its receivables. It shows
the average number of days it takes to collect debt. It also shows the quality
of receivables, the shorter the collection period the better for the firm vice
versa
measures how efficient the firm is in collection of its receivables. It shows
the average number of days it takes to collect debt. It also shows the quality
of receivables, the shorter the collection period the better for the firm vice
versa
ACP
= (Average Debtors x 365)/ Credit Sales
= (Average Debtors x 365)/ Credit Sales
Or
(Debtors
x 365)/ Net sales
x 365)/ Net sales
