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FSA Ratios

FSA Ratios

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Published by: dilfarazz on Feb 18, 2010
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07/08/2011

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BUSINESS SYSTEMSBANGALOREHK/0403
FINANCIAL STATEMENT ANALYSIS - RATIOS
1.Financial statements - i.e., Balance Sheet and Profit & Loss account, provide a wealth of information. If properly analysed and interpreted, they can provide valuable insights into afirm’s performance and position.2.Before undertaking any analysis, the analyst must clearly define -a)The viewpoint taken (e.g. lender, investor, management etc.) b)The objectives of the analysis andc)The standards of comparison.In financial analysis there is always a temptation to ‘run all the numbers’ - yet only a fewrelationships will generally yield the information and insights the analyst really needs.3.There are many analytical techniques, chief among them being-Ratio Analysis, Du Pont Analysis-Fund Flow & Cash flow Analysis-Time Series-Common Size AnalysisThis note is restricted to ratio analysis.3.1
RATIO ANALYSIS
A ratio relates any magnitude to any other, such as net profits to sales or net profit to totalassets. The choices are limited only by the analyst’s imagination.The actual usefulness of any particular ratio depends on the specific ‘objectives’ of theanalysis. Ratios serve best to point out changes in financial conditions or operating performance. They help to illustrate the trends and patterns of such changes. These mayindicate to the analyst, the risks and opportunities for the business under review.A further caution should be noted here. Performance assessment based on financialstatements deals with the past data and conditions. Hence it may be difficult to extrapolatefuture expectations. Yet decisions are taken based on past financial analysis, which affect thefuture!The following are some of the key ratios:
i)Liquidity Ratios - Current Ratio,- Acid Test Ratio (Quick Ratio)ii)Leverage Ratios- Debt Equity Ratio- Debt – Service – Coverage Ratio
 
iii) Turnover Ratios- Inventory Turnover Ratio- Average collection period- Fixed Assets Turnover Ratioiv)Profitability Ratios- Net Profit to Sales- Return on Investment- Return on Equity- Earnings per sharev)Valuation Ratios- Price earnings ratio- Yield
Table 1 gives some of the important ratios and their formulae. Table 2 gives the relevantratios from different viewpoints.a)LIQUIDITY RATIOS:Liquidity refers to the ability of a firm to meet its obligations in the short run, usually oneyear. A very low ratio indicates that the firm may default on short-term commitments andwould therefore be considered risky. At the same time a very high ratio may indicateinefficient use of potential.(i)Current RatioCurrent AssetsCurrent LiabilitiesCurrent Assets include cash, marketable securities, debtors,inventories, loans and advances and prepaid expenses. Current liabilitiesconsist of loans and advances (taken), trade creditors, accrued expenses and provisions.This is a very popular ratio. Though it would be arbitrary todefine an ideal ratio without going into the type of industry, market conditionsetc., banks and lenders usually insist on a minimum of 1.25 - 1.33.(ii)Acid test Ratio Quick AssetsCurrent LiabilitiesQuick assets are current assets excluding inventories.This is a more stringent measure of liquidity, as inventories are considered to be least liquid of the current assets and hence excluded. b)LEVERAGE RATIOS:Leverage refers to the use of debt finance. Debt is cheaper than equity, but is also ariskier source of finance. There are structural ratios and coverage ratios of leverage.Structural ratios indicate the proportion or use of debt and equity in the financial structureof the Company. Coverage ratios indicate the relationship between the debt servicingcommitments and the sources for meeting these burdens. Though norms would have to be based on relative risk, size and nature of industry and market conditions, the usualexpectations of lenders are indicated for an ‘average’ enterprise. High leverage ratioindicates that the company is exposed to high risk of foreclosure / liquidation in case of 
 
default. Low leverage ratios indicate that the management is conservative and notaggressive and it also indicates high security for the lenders, and consequently a good borrowing potential.(i)Debt / EquityDebtDebt = Long term debtEquityEquity = Paid up capital and ReservesThe norms range between a maximum of 1:1 and 2:1 and in somecapital-intensive industries it could be as high as 4:1. (For e.g. shipping)(ii)Interest Coverage Ratio E B I T (Earnings Before Interest & Tax)Debt interestInstitutional norms range between 1.5 to 2.(iii)Debt - Service coverage ratioE B I T + DepreciationInterest + installment of Loan RepaymentThis indicates resource availability for servicing debts, paying interest andinstallment falling due for payment during the year.Institutional Norms range between 1.3 - 1.5c)TURNOVER RATIOS:These ratios measure how efficiently assets have been employed in the firm. They are based on the relationship between activity level (e.g. sales) and levels of various assets.The higher the ratio the better the usage of the asset. However, one has to look for moderation in these ratios, to avoid the risks of over use of assets.(i)Inventory Turnover Ratio Net SalesAverage inventoryHigh ratio indicates effective utilization of inventory in terms of costs andcycle time. Care should be taken that the inventory level is not too low toresult in frequent stock outs. Conversely low ratio would indicate inefficientinventory management.(ii)Average collection periodAverage ReceivablesAverage Sales per dayThis could be compared with the firm’s credit terms to judge the efficiency of receivables Management.(iii)Receivables Turnover Ratio Net SalesAverage ReceivablesThe higher the ratio the better the utilization. Obviously, the shorter thecollection period, the higher the receivables turnover ratio and vice versa.

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