Financial ratio analysis at a glance

Financial ratio analysis is performed by comparing two items in the financial statements. The resulting ratio can be interpreted in a new way which is not possible when interpreting the items one at a time. One glance at a ratio gives us an excellent overview of a company`s financial position.

Financial ratios can be classified into ratios that measure:  

• Profitability 
• Liquidity
• Management efficiency
• Leverage
• Valuation & growth.

Normally expressed in percentage by multiplying the decimal number by 100%.

 

 Here is a list of financial ratio-

Profitability Ratios

• Gross Profit Rate = Gross Profit / Net Sales Evaluates how much gross profit is generated from sales. Gross profit is equal to net sales (sales minus sales returns, discounts, and allowances) minus cost of sales.
• Return on Sales = Net Income / Net Sales Also known as "net profit margin" or "net profit rate", it measures the percentage of income derived from dollar sales. Generally, the higher the ROS the better.
• Return on Assets = Net Income / Average Total Assets In financial analysis, it is the measure of the return on investment. ROA is used in evaluating management's efficiency in using assets to generate income.
• Return on Stockholders' Equity = Net Income / Average Stockholders' Equity Measures the percentage of income derived for every dollar of owners' equity.

Liquidity Ratios

• Current Ratio = Current Assets / Current Liabilities Evaluates the ability of a company to pay short-term obligations using current assets (cash, marketable securities, current receivables, inventory, and prepayments).
• Acid Test Ratio = Quick Assets / Current Liabilities Also known as "quick ratio", it measures the ability of a company to pay short-term obligations using the more liquid types of current assets or "quick assets" (cash, marketable securities, and current receivables).
• Cash Ratio = ( Cash + Marketable Securities ) / Current Liabilities Measures the ability of a company to pay its current liabilities using cash and marketable securities. Marketable securities are short-term debt instruments that are as good as cash.
• Net Working Capital = Current Assets - Current Liabilities Determines if a company can meet its current obligations with its current assets; and how much excess or deficiency there is.

Management Efficiency Ratios

• Receivable Turnover = Net Credit Sales / Average Accounts Receivable Measures the efficiency of extending credit and collecting the same. It indicates the average number of times in a year a company collects its open accounts. A high ratio implies efficient credit and collection process.
• Days Sales Outstanding = 360 Days / Receivable Turnover Also known as "receivable turnover in days", "collection period". It measures the average number of days it takes a company to collect a receivable. The shorter the DSO, the better. Take note that some use 365 days instead of 360.
• Inventory Turnover = Cost of Sales / Average Inventory Represents the number of times inventory is sold and replaced. Take note that some authors use Sales in lieu of Cost of Sales in the above formula. A high ratio indicates that the company is efficient in managing its inventories.
• Days Inventory Outstanding = 360 Days / Inventory Turnover Also known as "inventory turnover in days". It represents the number of days inventory sits in the warehouse. In other words, it measures the number of days from purchase of inventory to the sale of the same. Like DSO, the shorter the DIO the better.
• Accounts Payable Turnover = Net Credit Purchases / Ave. Accounts Payable Represents the number of times a company pays its accounts payable during a period. A low ratio is favored because it is better to delay payments as much as possible so that the money can be used for more productive purposes.
• Days Payable Outstanding = 360 Days / Accounts Payable Turnover Also known as "accounts payable turnover in days", "payment period". It measures the average number of days spent before paying obligations to suppliers. Unlike DSO and DIO, the longer the DPO the better (as explained above).
• Operating Cycle = Days Inventory Outstanding + Days Sales Outstanding Measures the number of days a company makes 1 complete operating cycle, i.e. Purchase merchandise, sell them, and collect the amount due. A shorter operating cycle means that the company generates sales and collects cash faster.
• Cash Conversion Cycle = Operating Cycle - Days Payable Outstanding CCC measures how fast a company converts cash into more cash. It represents the number of days a company pays for purchases, sells them, and collects the amount due. Generally, like operating cycle, the shorter the CCC the better.
• Total Asset Turnover = Net Sales / Average Total Assets Measures overall efficiency of a company in generating sales using its assets. The formula is similar to ROA, except that net sales is used instead of net income.

Leverage Ratios

• Debt Ratio = Total Liabilities / Total Assets Measures the portion of company assets that is financed by debt (obligations to third parties). Debt ratio can also be computed using the formula: 1 minus Equity Ratio.
• Equity Ratio = Total Equity / Total Assets Determines the portion of total assets provided by equity (i.e. Owners' contributions and the company's accumulated profits). Equity ratio can also be computed using the formula: 1 minus Debt Ratio.
  The reciprocal of equity ratio is known as equity multiplier, which is equal to total assets divided by total equity.
• Debt-Equity Ratio = Total Liabilities / Total Equity Evaluates the capital structure of a company. A D/E ratio of more than 1 implies that the company is a leveraged firm; less than 1 implies that it is a conservative one.
• Times Interest Earned = EBIT / Interest Expense Measures the number of times interest expense is converted to income, and if the company can pay its interest expense using the profits generated. EBIT is earnings before interest and taxes.

Valuation and Growth Ratios

• Earnings per Share = ( Net Income - Preferred Dividends ) / Average Common Shares Outstanding EPS shows the rate of earnings per share of common stock. Preferred dividends is deducted from net income to get the earnings available to common stockholders.
• Price-Earnings Ratio = Market Price per Share / Earnings per Share Used to evaluate if a stock is over- or under-priced. A relatively low P/E ratio could indicate that the company is under-priced. Conversely, investors expect high growth rate from companies with high P/E ratio.
• Dividend Pay-out Ratio = Dividend per Share / Earnings per Share Determines the portion of net income that is distributed to owners. Not all income is distributed since a significant portion is retained for the next year's operations.
• Dividend Yield Ratio = Dividend per Share / Market Price per Share Measures the percentage of return through dividends when compared to the price paid for the stock. A high yield is attractive to investors who are after dividends rather than long-term capital appreciation.
• Book Value per Share = Common SHE / Average Common Shares Indicates the value of stock based on historical cost. The value of common shareholders' equity in the books of the company is divided by the average common shares outstanding.

Economics : Art Or Science

A controversial topic .

An economist David Rosenberg, former chief economist at Merrill Lynch once said , “Why did God invent economists?”

“To make weathermen feel good about themselves.”

There are some reasons for this statement.

Economics cant be considered as science as Science is a systematized body of knowledge ascertainable by observation 

and experiment. It is a body of generalizations, principles, theories or laws which traces out a casual relationship 

between causes and results.

Economics can define the causes and result but cannot do so with presicion.Just cause price of sugar increase by 1 dollar does not mean price of tea will increase by 1 dollar.

Again markets are frequently ahead of, and often out of sync with, the economy.economics follows

 the market but the market does not always follow economics .

Models are of limited utility.

correlation does not always mean causation.

There are two kinds of science:

Positive Science

Normative Science or Prescriptive Science

Some claim,

Economics is a positive science because:

Firstly, economists collect the facts.

Secondly, they analyze them and derive result.

Thirdly, they determine the relationship between facts and results.

Finally, they give a title to the relationship.

Economics is normative science because:

Firstly, economists points out different economic problems.

Secondly, they analyse them in the light of statistics or facts and figures.

Finally, they advise policies, laws, theories to solve the problems.

Economics is an art because:

Economists suggest policies along with their implementation procedures to solve the economic problem.

Thus, economics is a science as well as an art.

Types of goods

Normal goods - the quantity demanded of such commodities increases as the consumer’s income increases and decreases as the consumer’s income decreases. Such goods are called normal goods.

Giffen goods - a Giffen good is an inferior good which people consume more of as price rises, violating the law of demand.. In the Giffen good situation, cheaper close substitutes are not available. Because of the lack of substitutes, the income effect dominates, leading people to buy more of the good, even as its price rises.

Substitutes goods- substitute good for another kind insofar as the two kinds of goods can be consumed or used in place of one another in at least some of their possible usesn increase in price for one kind of good (ceteris paribus) will result in an increase in demand for its substitute goods, and a decrease in price (ceteris paribus, again) will result in a decrease in demand for its substitutes.

Complementary goods - A complementary good or complement good in economics is a good which is consumed with another good;if goods A and B were complements, more of good A being bought would result in more of good B also being bought and vice versa eg car and Petrol. If the demand for car increases then the demand for petrol also increases.

Consumer surplus and price elasticity of demand

Consumer surplus and price elasticity of demand 

Inelastic Demand means fixed demand ( demand does not changes with a change in price).
When demand is inelastic, there is a greater potential of consumer surplus because there are some consumers who are willing to pay a higher price to consume that product. Whatever the price, the quantity demanded remains the same.
 

Inelastic Demand means consumers are willing to pay a higher price for buying the commodity.
Here,Consumers are willing to pay P1 for Q1 quantity of commodity.
But they actually pay P.
Here,triangle PP1AE is the consumer surplus.

Elastic Demand means flexible demand (demand changes with a change in price, law of demand follows).

When the demand for a good or service is perfectly elastic, consumer surplus is zero because with the increase in price of the commodity, the demand would decrease and vice versa. And would reduce the consumer surplus.

 

Here P is the the market price and
P1 is the price the consumer is willing to pay.
Now, suppose the price increases From P to Pn.
With the increase in price from P to Pn, Consumer surplus falls from PnPBA to PnPB1A1.

Elastic Demand means consumers are not willing to pay a higher price for buying the commodity.
With the increase in small Price, Demand will fall much more than proportion.
Here, Triangle PP1AB is the consumer surplus.

Change in Consumer Surplus: Price Increase

Consumer surplus = Amount a consumer is willing to pay – amount he actually pays

Consumer Surplus

Consumer surplus is a measure of the welfare that people gain from the consumption of goods and services with regard to the prices they pay for it.

Consumer surplus is the difference between the total amount that consumers are willing to pay and what they actually pay for a good or service (indicated by the demand curve) . Consumer surplus is a measure of welfare. 

The amount of consumer surplus can be derived from the demand curve. The price of a commodity is determined by the interaction of demand and supply curve. 

Consumers always like to feel like they are getting a good deal on the goods and services they buy and consumer surplus is simply an economic measure of this satisfaction. For example, assume a consumer goes out shopping for a CD player and he or she is willing to spend $250. When this individual finds that the player is on sale for $150, economists would say that this person has a consumer surplus of $100.

What is a Market?

A market is a place where buyers and sellers meet and interact. In today’s internet era, buyers and sellers don’t meet necessarily, but they interact and and perform their desired roles.

Market structure is best defined as the organisational and other characteristics of a market. There are some characteristics which affect the nature of competition and pricing.

The most important features of market structure are:

• The number of firms.
• The market share of the largest firms
• The nature of costs
• The degree to which the industry is integrated
• The extent of product differentiation
• The structure of buyers in the industry

Summary of market structures

Changes in Market Equilibrium

Market equilibrium refers to a situation in which quantity demanded is equal to the quantity supplied, the point at which demand and supply curve meets. 

Increase in Supply results in a right ward shift in supply curve, leading to a new equilibrium point( the intersection point of demand and new supply curve.) 

 

· With the increase in supply, supply curve shifts rightward.

· The new equilibrium point is E1

· It would result in fall in prices and increase in quanity demanded.

Increase in demand results in a right ward shift in demand curve, leading to a new equilibrium point( the intersection point of demand and new supply curve.)

· With the increase in demand, demand curve shifts rightward.

· The new equilibrium point is E1

· It would result in rise in prices and increase in quanity demanded.

Simultanous Increase in demand and supply results in a right ward shift in demand curve and supply curve, leading to a new equilibrium point( the intersection point of demand and new supply curve). The changes in both demand and supply is a real market situation, The supply and demand curve changes as a result of change in market conditions.

· With the simultaneous increase in demand and supply, demand and supply curves shift rightward.

· The new equilibrium point is E1

· Here, It would result in rise in price P1 and increase in quanity demanded Q1.