Liquidity ratio

It’s a ratio that tells one’s ability to pay off its debt
as and when they become due. In other words, we
can say this ratio tells how quickly a company can
convert its current assets into cash so that it can pay
off its liability on a timely basis. Generally, Liquidity
and short-term solvency are used together.
The liquidity ratio affects the credibility of the
company as well as the credit rating of the company.
If there are continuous defaults in repayment of a
short-term liability then this will lead to
bankruptcy. Hence this ratio plays important role in
the financial stability of any company and credit
ratings

Types

1.Current ratio
2.Acid Test Ratio or
Quick Ratio
1.Current ratio
This ratio measures the financial strength of the
company. Generally, 2:1 is treated as the ideal ratio,
but it depends on industry to industry.

Formula: Current Assets/ Current Liability,

where:-

Current Assets = Stock, debtor, cash and bank,

receivables, loan and advances, and other current
assets.

Current Liability = Creditor, short-term loan,

bank overdraft, outstanding expenses, and other
current liability
2.Acid Test Ratio or Quick
Ratio
This ratio is the best measure of liquidity in the
company. This ratio is more conservative than the
current ratio. The quick asset is computed by
adjusting current assets to eliminate those assets
which are not in cash.
Generally, 1:1 is treated as an ideal ratio.
Formula: Quick Assets/ Current Liability,
where,
Quick Assets = Current Assets – Inventory –
Prepaid Expenses
Profitability Ratios?
Profitability ratios are financial metrics used by
analysts and investors to measure and evaluate the
ability of a company to generate income (profit)
relative to revenue, balance sheet assets, operating
costs, and shareholders’ equity during a specific
period of time. They show how well a company
utilizes its assets to produce profit and value to
shareholders.
A higher ratio or value is commonly sought-after
by most companies, as this usually means the
business is performing well by generating
revenues, profits, and cash flow. The ratios are
most useful when they are analyzed in comparison
to similar companies or compared to previous
periods. The most commonly used profitability
ratios are examined below.

1.Gross profit margin

2.Operating profit margin
3.Net profit margin
4.Return on Capital
Employed (ROCE)

1.Gross profit margin

compares gross profit to sales revenue. This shows
how much a business is earning, taking into
account the needed costs to produce its goods and
services. A high gross profit margin ratio reflects a
higher efficiency of core operations, meaning it can
still cover operating expenses, fixed costs,
dividends, and depreciation, while also providing
net earnings to the business. On the other hand, a
low profit margin indicates a high cost of goods
sold, which can be attributed to adverse
purchasing policies, low selling prices, low sales,
stiff market competition, or wrong sales promotion
policies.

Example of Gross Margin Ratio

To illustrate the gross margin ratio, let's assume
that a company has net sales of RS. 800,000 and
its cost of goods sold is RS. 600,000. As a result,
its gross profit is RS. 200,000 (net sales of RS.
800,000 minus its cost of goods sold of RS.
600,000) and its gross margin ratio is 25% (gross
profit of RS. 200,000 divided by net sales of RS.
800,000).
Note: Gross margin ratios vary between industries.
Therefore, you should compare a company's gross
margin ratio to other companies in the same
industry and to its own past ratios or its planned
ratios.

2.Operating profit margin

looks at earnings as a percentage of sales before
interest expense and income taxes are deduced.
Companies with high operating profit margins are
generally more well-equipped to pay for fixed costs
and interest on obligations, have better chances to
survive an economic slowdown, and are more
capable of offering lower prices than their
competitors that have a lower profit margin.
Operating profit margin is frequently used to
assess the strength of a company’s management
since good management can substantially improve
the profitability of a company by managing its
operating costs.
3.Net profit margin
is the bottom line. It looks at a company’s net
income and divides it into total revenue. It
provides the final picture of how profitable a
company is after all expenses, including interest
and taxes, have been taken into account. A reason
to use the net profit margin as a measure of
profitability is that it takes everything into
account. A drawback of this metric is that it
includes a lot of “noise” such as one-time expenses
and gains, which makes it harder to compare a
company’s performance with its competitors.
4.Return on Capital Employed
(ROCE)
Return on capital employed can be especially
useful when comparing the performance of
companies in capital-intensive sectors, such as
utilities and telecoms. This is because, unlike other
fundamentals such as return on equity (ROE), which
only analyzes profitability related to a company’s
shareholders’ equity, ROCE considers debt and
equity. This can help neutralize financial
performance analysis for companies with
significant debt.
Ultimately, the calculation of ROCE tells you the
amount of profit a company is generating per $1 of
capital employed. The more profit per $1 a
company can generate, the better. Thus, a higher
ROCE indicates stronger profitability across
company comparisons.
For a company, the ROCE trend over the years can
also be an important indicator of performance.
Investors tend to favor companies with stable and
rising ROCE levels over companies where ROCE is
volatile or trending lower.

Solvency Ratio
A solvency ratio is a performance metric that helps
us examine a company’s financial health. In
particular, it enables us to determine whether the
company can meet its financial obligations in the
long term.
The metric is very useful to lenders, potential
investors, suppliers, and any other entity that
would like to do business with a particular
company. It usually compares the entity’s
profitability with its obligations to determine
whether it is financially sound. In that regard, a
higher or strong solvency ratio is preferred, as it is
an indicator of financial strength. On the other
hand, a low ratio exposes potential financial
hurdles in the future.

1.Debt-to-Equity (D/E) Ratio

2.Interest Coverage Ratio

1.Debt-to-Equity (D/E) Ratio

Often abbreviated as D/E, the debt-to-equity
ratio establishes a company’s total debts relative to
its equity. To calculate the ratio, first, get the sum
of its debts. Divide the outcome by the company’s
total equity. This is used to measure the degree to
which a company is using debt to fund operations
(leverage).
2.Interest Coverage Ratio
With the interest coverage ratio, we can determine
the number of times that a company’s profits can
be used to pay interest charges on its debts. To
calculate the figure, divide the company’s profits
(before subtracting any interests and taxes) by its
interest payments.
The higher the value, the more solvent the
company. In other words, it means the day-to-day
operations are yielding enough profit to meet its
interest payments.
Turnover Ratio
The portfolio turnover ratio is the rate of which
assets in a fund are bought and sold by the
portfolio managers. In other words, the portfolio
turnover ratio refers to the percentage change of
the assets in a fund over a one-year period.

1.Fixed Asset Turnover

2.Inventory Turnover Ratio
3.Receivables Turnover
Ratios

1.Fixed Asset Turnover

Fixed Asset Turnover (FAT) is an efficiency ratio
that indicates how well or efficiently a business
uses fixed assets to generate sales. This ratio
divides net sales by net fixed assets, calculated
over an annual period. The net fixed assets include
the amount of property, plant, and equipment, less the
accumulated depreciation. Generally, a higher
fixed asset ratio implies more effective utilization
of investments in fixed assets to generate revenue.
This ratio is often analyzed alongside leverage and
profitability ratios.

2.Inventory Turnover Ratio

The inventory turnover ratio, also known as the stock
turnover ratio, is an efficiency ratio that measures how
efficiently inventory is managed. The inventory
turnover ratio formula is equal to the cost of goods
sold divided by total or average inventory to show how
many times inventory is “turned” or sold during a
period. The ratio can be used to determine if there are
excessive inventory levels compared to sales.
Inventory Turnover Ratio Formula
The formula for calculating the ratio is as follows:

Where:
Cost of goods sold is the cost attributed to the
production of the goods that are sold by a company over
a certain period. The cost of goods sold by a company
can found on the company’s income statement.
Average inventory is the mean value of inventory
throughout a certain period.
Note: an analyst may use either average or end-of-
period inventory values.

3.Receivables Turnover
Ratios
Accounts receivable are effectively interest-free loans
that are short-term in nature and are extended by
companies to their customers. If a company generates a
sale to a client, it could extend terms of 30 or 60 days,
meaning the client has 30 to 60 days to pay for the
product.
The receivables turnover ratio measures the efficiency
with which a company is able to collect on its
receivables or the credit it extends to customers. The
ratio also measures how many times a company's
receivables are converted to cash in a certain period of
time. The receivables turnover ratio is calculated on an
annual, quarterly, or monthly basis.

Earning Ratio
1.Price Earnings Ratio
The Price Earnings Ratio (P/E Ratio) is the relationship
between a company’s stock price and earnings per share
(EPS). It is a popular ratio that gives investors a better
sense of the value of the company. The P/E ratio shows
the expectations of the market and is the price you must
pay per unit of current earnings (or future earnings, as
the case may be).
Earnings are important when valuing a company’s stock
because investors want to know how profitable a
company is and how profitable it will be in the future.
Furthermore, if the company doesn’t grow and the
current level of earnings remains constant, the P/E can
be interpreted as the number of years it will take for the
company to pay back the amount paid for each share.
2.Earnings per Share (EPS)
Earnings per share (EPS) is a key metric used to
determine the common shareholder’s portion of the
company’s profit. EPS measures each common share’s
profit allocation in relation to the company’s total
profit. IFRS uses the term “ordinary shares” to refer to
common shares.
The EPS figure is important because it is used by
investors and analysts to assess company performance,
to predict future earnings, and to estimate the value of
the company’s shares. The higher the EPS, the more
profitable the company is considered to be and the more
profits are available for distribution to its shareholders.