Q.1 What are financial ratios, why do we use financial ratios?

, how many categories of

financial ratios are there?

Financial Ratios

Financial ratios are useful indicators of a firm's performance and financial situation. Most
ratios can be calculated from information provided by the financial statements. Financial
ratios can be used to analyze trends and to compare the firm's financials to those of other
firms. In some cases, ratio analysis can predict future bankruptcy.

Advantages of Ratio Analysis

It simplifies the financial statements.

It helps in comparing companies of different size with each other.
It helps in trend analysis which involves comparing a single company over a
period.
It highlights important information in simple form quickly. A user can judge a
company by just looking at few numbers instead of reading the whole financial
statements.

Four Basic Types of Financial Ratios Used to Measure a Company's Performance

Ratios can be divided into four major categories:

Liquidity
Solvency / Leverage (Funding Debt, Equity, Grants)
Profitability Sustainability
Operational Efficiency

Liquidity

The most common liquidity ratio is the current ratio, which is the ratio of current assets to
current liabilities. This ratio indicates a company's ability to pay its short-term bills. A
ratio of greater than one is usually a minimum because anything less than one means the
company has more liabilities than assets. A high ratio indicates more of a safety cushion,
which increases flexibility because some of the inventory items and receivable balances may
not be easily convertible to cash. Companies can improve the current ratio by paying down
debt, converting short-term debt into long-term debt, collecting its receivables faster and
buying inventory only when necessary.

Solvency/Leverage (Funding Debt, Equity, Grants)

Solvency ratios indicate financial stability because they measure a company's debt relative
to its assets and equity. A company with too much debt may not have the flexibility to
manage its cash flow if interest rates rise or if business conditions deteriorate. The common
solvency ratios are debt-to-asset and debt-to-equity. The debt-to-asset ratio is the ratio of
total debt to total assets. The debt-to-equity ratio is the ratio of total debt to shareholders'
equity, which is the difference between total assets and total liabilities.

Profitability Sustainability

Profitability ratios indicate management's ability to convert sales dollars into profits and
cash flow. The common ratios are gross margin, operating margin and net income margin.
The gross margin is the ratio of gross profits to sales. The gross profit is equal to sales
minus cost of goods sold. The operating margin is the ratio of operating profits to sales and
net income margin is the ratio of net income to sales. The operating profit is equal to the
gross profit minus operating expenses, while the net income is equal to the operating profit
minus interest and taxes. The return-on-asset ratio, which is the ratio of net income to total
assets, measures a company's effectiveness in deploying its assets to generate profits. The
return-on-investment ratio, which is the ratio of net income to shareholders' equity,
indicates a company's ability to generate a return for its owners.

Operational Efficiency

Two common efficiency ratios are inventory turnover and receivables turnover. Inventory
turnover is the ratio of cost of goods sold to inventory. A high inventory turnover ratio
means that the company is successful in converting its inventory into sales. The receivables
turnover ratio is the ratio of credit sales to accounts receivable, which tracks outstanding
credit sales. A high accounts receivable turnover means that the company is successful in
collecting its outstanding credit balances.

Question 2 What does each ratio measure ,write its significance

Current Ratio

The current ratio is a liquidity ratio which estimates the ability of a company to pay back
short-term obligations. This ratio is also known as cash asset ratio, cash ratio, and liquidity
ratio. A higher current ratio indicates the higher capability of a company to pay back its
debts. The formula used for computing current ratio is:

Current Ratio = Current Assets / Current Liabilities

Quick Ratio

The quick ratio is a measure of a company's ability to meet its short-term obligations using
its most liquid assets (near cash or quick assets). Quick assets include those current assets
that presumably can be quickly converted to cash at close to their book values. Quick ratio
is viewed as a sign of a company's financial strength or weakness; it gives information
about a companys short term liquidity. The ratio tells creditors how much of the
company's short term debt can be met by selling all the company's liquid assets at very
short notice. The quick ratio is also known as the acid-test ratio

Acid-Test Ratio / quick ratio = (Total Current Assets Inventories - Pre Paid Expenses) /
Current Liabilities

Alternative and more accurate formula for the quick ratio is the following:

Quick ratio = (Cash and cash equivalents + Marketable securities + Accounts receivable) /
Current Liabilities

The formula's numerator consists of the most liquid assets (cash and cash equivalents) and
high liquid assets (liquid securities and current receivables).

Inventory Turnover Ratio Managing inventory levels is important for most businesses and
this is especially true for retailers and any company that sells physical goods. The inventory
turnover ratio is a key measure for evaluating just how efficient management is at
managing company inventory and generating sales from it.

Generally calculated As:

Inventory Turnover = Sales / Avg. Inventory

However It may also be calculated as

Inventory Turnover = Cost Of Goods Sold /Average Inventory

Or

Inventory turnover In days = Average Inventory / Cost Of Goods Sold x 365

It is important to remember that the average inventory for the period is used. From here,
the days in inventory formula can be rewritten as the numerator multiplied by the inverse
of the denominator.

Or

Inventory Turnover In days = Avg. Inventory /Sales x 365

Days Sales Outstanding ----- DSO Ratio Formula

A measure of the average number of days that a company takes to collect revenue after a
sale has been made. A low DSO number means that it takes a company fewer days to
collect its accounts receivable. A high DSO number shows that a company is selling its
product to customers on credit and taking longer to collect money.

Days sales outstanding is calculated as:

'Average Collection Period'

The approximate amount of time that it takes for a business to receive payments
owed, in terms of receivables, from its customers and clients.

Calculated as:

Where:
Days = Total amount of days in period
AR = Average amount of accounts receivables
Credit Sales = Total amount of net credit sales during period

Accounts Receivable Turnover Ratio

An accounting measure used to quantify a firm's effectiveness in extending credit as well as
collecting debts. The receivables turnover ratio is an activity ratio, measuring how
efficiently a firm uses its assets.

Accounts receivable turnover is the ratio of net credit sales of a business to its average
accounts receivable during a given period, usually a year. It is an activity ratio which
estimates the number of times a business collects its average accounts receivable balance
during a period.
Receivable turnover = net Credit Sales/Average Accounts Receivable

Gross Profit Margin

A financial metric used to assess a firm's financial health by revealing the proportion of
money left over from revenues after accounting for the cost of goods sold. Gross profit
margin serves as the source for paying additional expenses and future savings.

*100

OPERATING PROFIT MARGIN RATIO

The operating profit margin is a type of profitability ratio known as a margin ratio. The
information with which to calculate the operating profit margin comes from a company's
income statement. It is used to measure a company's pricing strategy and operating
efficiency.

Operating margin is a measurement of what proportion of a company's revenue is left over

after paying for variable costs of production such as wages, raw materials, etc. A healthy
operating margin is required for a company to be able to pay for its fixed costs, such as
interest on debt. Also known as "operating profit margin" or "net profit margin"

Operating Profit Margin = Operating Income/Sales Revenue * 100

Working Capital

A measure of both a company's efficiency and its short-term financial health. The working
capital is calculated as:

The working capital ratio (Current Assets/Current Liabilities) indicates whether a

company has enough short term assets to cover its short term debt. Anything below 1
indicates negative W/C (working capital). While anything over 2 means that the company is
not investing excess assets. Most believe that a ratio between 1.2 and 2.0 is sufficient. Also
known as "net working capital".

'Earnings Per Share ----- EPS'

The portion of a company's profit allocated to each outstanding share of common stock.
Earnings per share serves as an indicator of a company's profitability.

Calculated as:
When calculating, it is more accurate to use a weighted average number of shares
outstanding over the reporting term, because the number of shares outstanding can change
over time. However, data sources sometimes simplify the calculation by using the number
of shares outstanding at the end of the period.

'Fixed-Asset Turnover Ratio'

A financial ratio of net sales to fixed assets. The fixed-asset turnover ratio measures a
company's ability to generate net sales from fixed-asset investments - specifically property,
plant and equipment (PP&E) - net of depreciation. A higher fixed-asset turnover ratio
shows that the company has been more effective in using the investment in fixed assets to
generate revenues.

The fixed-asset turnover ratio is calculated as:

'Asset Turnover Ratio'

The amount of sales or revenues generated per dollar of assets. The Asset Turnover ratio is
an indicator of the efficiency with which a company is deploying its assets.

Asset Turnover = Sales or Revenues / Total Assets

Generally speaking, the higher the ratio, the better it is, since it implies the company is
generating more revenues per dollar of assets. But since this ratio varies widely from one
industry to the next, comparisons are only meaningful when they are made for different
companies in the same sector.

Debt Ratios:

The debt ratio compares a company's total debt to its total assets, which is used to gain a
general idea as to the amount of leverage being used by a company. A low percentage
means that the company is less dependent on leverage, i.e., money borrowed from and/or
owed to others. The lower the percentage, the less leverage a company is using and the
stronger its equity position. In general, the higher the ratio, the more risk that company is
considered to have taken on.

Formula:
Times Interest Earned Ratio

Times interest earned (also called interest coverage ratio) is the ratio of earnings before
interest and tax (EBIT) of a business to its interest expense during a given period. It is a
solvency ratio measuring the ability of a business to pay off its debts.

Times Interest Earned

Earnings before Interest and Tax
=
Interest Expense

'Return On Total Assets - ROTA'

A ratio that measures a company's earnings before interest and taxes (EBIT) against its
total net assets. The ratio is considered an indicator of how effectively a company is using
its assets to generate earnings before contractual obligations must be paid.

To calculate ROTA:

of 'Return On Equity - ROE'

The amount of net income returned as a percentage of shareholders equity. Return on

equity measures a corporation's profitability by revealing how much profit a company
generates with the money shareholders have invested.

ROE is expressed as a percentage and calculated as:

Return on Equity = Net Income/Shareholder's Equity

Price-Earnings Ratio ---- P/E Ratio

A valuation ratio of a company's current share price compared to its per-share earnings.
P/E Ratio = Market Value per Share / Earnings per Share (EPS)

Book-To-Market Ratio

A ratio used to find the value of a company by comparing the book value of a firm to its
market value. Book value is calculated by looking at the firm's historical cost, or
accounting value. Market value is determined in the stock market through its market
capitalization.

Formula:

Book o Market = Book Value Of Firm / Market Value Of Firm

Q.3 What are the limitations of financial ratio analysis ?

Limitations:
Despite usefulness, financial ratio analysis has some disadvantages. Some key demerits of
financial ratio analysis are:

1. Different companies operate in different industries each having different

environmental conditions such as regulation, market structure, etc. Such factors are
so significant that a comparison of two companies from different industries might be
misleading.
2. Financial accounting information is affected by estimates and assumptions.
Accounting standards allow different accounting policies, which impairs
comparability and hence ratio analysis is less useful in such situations.
3. Ratio analysis explains relationships between past information while users are more
concerned about current and future information.

Here are some limitations of ratios that all analysts must be aware of:

1. Ratios are only as informative as the financial statements on which they are
based. If the underlying accounting is suspect, then the ratios will be
suspect. Ratios are sensitive to changes in accounting assumptions and to window
dressing techniques that organizations use to make their financial results look
better. Furthermore, ratios are not very useful in detecting fraud (or unintentional
mistakes) in the accounting system.
2. Ratio analysis is probably most accurate for organizations with a narrow line of
products or services. The more complicated the organization becomes, the more
difficult a good ratio analysis is.
3. Inflation can distort the financial statements (particularly the balance sheet). Any
problem in the financials caused by inflation can be passed on to ratios.
4. With some ratios it is difficult to tell where a ratio value changes from good to
bad. For example: How much liquidity is enough? How much is too much?
5. It is sometimes very difficult to draw overall conclusions about an organization
using ratios alone. Some ratios may be very good, while others are not very
 good. There is no clear and systematic way to sift all of the ratio information into a
single conclusion about an organizations overall health and performance.
6. Differences in accounting assumptions may make it difficult to compare ratios from
different organizations. Accounting assumptions can include inventory methods
such as last-in, first-out [LIFO] or first-in, first-out [FIFO] and depreciation
methods like Straight Line or Double Declining Balance.
7. Differences in ratio definitions may make it difficult to compare ratios from
different sources. There can be many different ways to compute the same ratio. This
can cause confusion or different answers for the same ratio name.