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4 reasons why ratios and proportions are so important 1. Markets can only do one of 3 things: go up, down, or sideways.

It's the job of the pattern recognition swing trader to determine whether you have an uptrend (higher lows) or a downtrend (lower highs). 2. Markets repeat with clocklike regularity, they do the same thing every day. 3. Ratios and proportions are leading indicators indicating the future of price movement as opposed to lagging indicators like oscillators, moving averages and Bollinger bands. 4. Each right triangle has a predictive nature making the risk/reward on each trade solidly in the traders favor. The Importance of Financial Ratios by Elizabeth Bell Understanding financial ratios is a key business skill for any business owner or entrepreneur. Financial ratios illustrate the strengths and weaknesses of a business. By examining ratios over time, a business owner can notice any unusual fluctuations in financial ratios and can note how the business is performing over time. Ratios are also helpful tools in financial analysis and forecasting; ratios allow entrepreneurs to set specific goals and to easily track progress toward those goals. It is important to choose financial ratios that are applicable to the business at hand. There are hundreds of financial ratios available, some of which apply to all businesses and some of which are industry-specific. Below are explanations of some of the most common financial ratios. Operating Margin = Operating Income / Net Sales This ratio shows how much of a companys revenue is left after paying off all operating expenses, such as employee salaries and raw material costs. A low operating margin is a sign that a business might not have enough revenue to pay off debt and other nonoperating costs. Gross Margin = (Revenue Cost of Goods Sold) / Revenue Gross margin is a representation of how much revenue remains after a company pays all of the direct costs associated with generating that revenue. The higher this ratio is, the more revenue the company has to pay off other expenses. ROE (Return on Equity) = Net Income / Shareholders Equity.

This ratio measures how much profit the shareholders investment has generated. A higher ROE percentage indicates that shareholders are receiving a better return on their investment. ROA (Return on Assets) = Net Income / Total Assets. This ratio measures how profitable a company is relative to its total assets. A high ROA indicates that management is effectively utilizing the companys assets to generate profit. Quick Ratio = (Current Assets Inventories) / Current Liabilities The quick ratio measures the liquidity of a company. The higher this ratio, the more liquid assets a company has to meet immediate financial obligations. Current Ratio = (Current Assets / Current Liabilities) The current ratio is another measure of liquidity. The current ratio is a bit more forwardlooking than the quick ratio; unlike the quick ratio, the current ratio includes inventories in current assets, because inventories can be sold over a short period of time to generate cash. ISCR (Interest-Service Coverage Ratio) = Net Operating Income / Interest Expense ISCR indicates how much cash a company has to pay interest on its debt. A high ISCR ratio means that a company is well-prepared to pay its upcoming interest expenses. DSCR (Debt-Service Coverage Ratio) = Net Operating Income / Total Debt Service DSCR measures the cash available to meet debt payments, including principal and interest payments. In some cases, Operating Cash Flow is substituted for Net Operating Income in the formula. A high DSCR ratio indicates that a company has enough cash flow to cover debt obligations. Debt to Equity Ratio = (Total Liabilities / Shareholders Equity) This ratio indicates how levered a company is. A high debt to equity ratio illustrates that a company is highly levered, or that it carries a lot of debt relative to shareholders equity. The appropriate debt to equity ratio depends on a companys industry and financial health. Receivables Collection Period = (Days x Accounts Receivable) / Credit Sales. This ratio provides the average number of days that it takes for a company to receive payments from customers. A lower number of days receivable indicates that a company is efficiently managing its accounts receivable process.

Days Payable Outstanding = Accounts Payable / Cost of Sales x Number of Days This ratio indicates how long a company takes to pay suppliers and vendors. The optimum number of days payable varies by company and by industry. Each company wants to have flexible payment terms to allow liquidity but does not want to incur pastdue invoices and fees. Inventory Turnover = 365 / (Cost of Goods Sold / Average Inventory) This ratio shows how many days inventory a company has on hand. A high inventory turnover indicates excess inventory and perhaps low sales. A low ratio might indicate strong sales or the need to increase inventory levels. Using these ratios is the first step to taking a deep look into the financials of a business. Ratios can illuminate unforeseen problems in a company and can highlight unexpected successes. Adding financial ratios into the financial planning process can be an invaluable tool to improving business performance.

IMPORTANCE OF RATIO ANALYSIS: As a tool of financial management, ratios are of crucial significance. Theimportance of ratio analysis lies in the fact that it presents facts on acomparative basis & enables the drawing of interference regarding theperformance of a firm. Ratio analysis is relevant in assessing the performanceof a firm in respect of the following aspects:1] Liquidity position,2] Long-term solvency,3] Operating efficiency,4] Overall profitability,5] Inter firm comparison6] Trend analysis. 1] LIQUIDITY POSITION:

With the help of Ratio analysis conclusion can be drawn regarding theliquidity position of a firm. The liquidity position of a firm would be satisfactory if it is able to meet its current obligation when they become due. A firm can besaid to have the ability to meet its short-term liabilities if it has sufficient liquidfunds to pay the interest on its short maturing debt usually within a year as wellas to repay the principal. This ability is reflected in the liquidity ratio of a firm.The liquidity ratio are particularly useful in credit analysis by bank & other suppliers of short term loans. 2] LONG TERM SOLVENCY:

Ratio analysis is equally useful for assessing the long-term financialviability of a firm. This respect of the financial position of a borrower is of concern to the long-term creditors, security analyst & the present & potentialowners of a business. The long-term solvency is measured by the leverage/capital structure & profitability ratio Ratio analysis s that focus on earning power & operating efficiency. 25Ratio analysis reveals the strength & weaknesses of a firm in thisrespect. The leverage ratios, for instance, will indicate whether a firm has areasonable proportion of various sources of finance or if it is heavily loaded withdebt in which ca Ratio analysis reveals the strength & weaknesses of a firm in thisrespect. The leverage ratios, for instance, will indicate whether a firm has areasonable proportion of various sources of finance or if it is heavily loaded withdebt in which case its solvency is exposed to serious strain. Similarly thevarious profitability ratios would reveal whether or not the firm is able to offer adequate return to its owners consistent with the risk involved. 3] OPERATING EFFICIENCY: Yet another dimension of the useful of the ratio analysis, relevant fromthe viewpoint of management, is that it throws light on the degree of efficiencyin management & utilization of its assets. The various activity ratios measuresthis kind of operational efficiency. In fact, the solvency of a firm is, in theultimate analysis, dependent upon the sales revenues generated by the use of its assets- total as well as its components. 4] OVERALL PROFITABILITY: Unlike the outsides parties, which are interested in one aspect of thefinancial position of a firm, the management is constantly concerned aboutoverall profitability of the enterprise. That is, they are concerned about theability of the firm to meets its short term as well as long term obligations to itscreditors, to ensure a reasonable return to its owners & secure optimumutilization of the assets of the firm. This is possible if an integrated view is taken& all the ratios are considered together. 5 ] INTER FIRM COMPARISON: Ratio analysis not only throws light on the financial position of firm butalso serves as a stepping-stone to remedial measures. This is made possibledue to inter firm comparison & comparison with the industry averages. A singlefigure of a particular ratio is meaningless unless it is related to some standardor norm. one of the popular

techniques is to compare the ratios of a firm with26Downloaded from a2zmba.blogspot.comthe industry average. It should be reasonably expected that the performance of a firm should be in broad conformity with that of the industry to which it belongs. An inter firm comparison would demonstrate the firms position vice-versa itscompetitors. If the results are at variance either with the industry average or with the those of the competitors, the firm can seek to identify the probablereasons & in light, take remedial measures. 6] TREND ANALYSIS: Finally, ratio analysis enables a firm to take the time dimension intoaccount. In other words, whether the financial position of a firm is improving or deteriorating over the years. This is made possible by the use of trend analysis.The significance of the trend analysis of ratio lies in the fact that the analystscan know the direction of movement, that is, whether the movement is favorableor unfavorable. For example, the ratio may be low as compared to the norm butthe trend may be upward. On the other hand, though the present level may besatisfactory but the trend may be a declining one. ADVANTAGES OF RATIO ANALYSIS Financial ratios are essentially concerned with the identification of significant accounting data relationships, which give the decision-maker insightsinto the financial performance of a company. The advantages of ratio analysiscan be summarized as follows:

Ratios facilitate conducting trend analysis, which is important for decision making and forecasting.

Ratio analysis helps in the assessment of the liquidity, operatingefficiency, profitability and solvency of a firm.

Ratio analysis provides a basis for both intra-firm as well as inter-firmcomparisons.27Downloaded from

The comparison of actual ratios with base year ratios or standardratios helps the management analyze the financial performance of the firm. LIMITATIONS OF RATIO ANALYSIS Ratio analysis has its limitations. These limitations are described below: 1] I nformation p roblems

Ratios require quantitative information for analysis but it is not decisiveabout analytical output .

The figures in a set of accounts are likely to be at least several monthsout of date, and so might not give a proper indication of the companyscurrent financial position.

W here historical cost convention is used, asset valuations in the balancesheet could be misleading. Ratios based on this information will not bevery useful for decision-making. 2] C om p arison of p erformance over time

W hen comparing performance over time, there is need to consider thechanges in price. The movement in performance should be in line withthe changes in price.

W hen comparing performance over time, there is need to consider thechanges in technology. The movement in performance should be in linewith the changes in technology.

Changes in accounting policy may affect the comparison of resultsbetween different accounting years as misleading.28Downloaded from 3] I nter-firm com p arison

Companies may have different capital structures and to makecomparison of performance when one is all equity financed and another is a geared company it may not be a good analysis.

Selective application of government incentives to various companiesmay also distort intercompany comparison. comparing the performanceof two enterprises may be misleading.

Inter-firm comparison may not be useful unless the firms compared areof the same size and age, and employ similar production methods andaccounting practices.

Even within a company, comparisons can be distorted by changes in theprice level.

Ratios provide only quantitative information, not qualitative information.

Ratios are calculated on the basis of past financial statements. They donot indicate future trends and they do not consider economic conditions. PURPOSE OF RATIO ANLYSIS: 1] To identify aspects of a businesses performance to aid decision making2] Quantitative process may need to be supplemented by qualitativeFactors to get a complete picture.3] 5 main areas:-

L iq u idity the ability of the firm to pay its way

I nvestment / shareholders information to enable decisions to be madeon the extent of the risk and the earning potential of a businessinvestment

G earing information on the relationship between the exposure of thebusiness to loans as opposed to share capital29Downloaded from

P rofitability

how effective the firm is at generating profits given salesand or its capital assets

F inancial the rate at which the company sells its stock and theefficiency with which it uses its assets ROLE OF RATIO ANALYSIS: It is true that the technique of ratio analysis is not a creative technique inthe sense that it uses the same figure & information, which is already appearingin the financial statement. At the same time, it is true that what can be achievedby the technique of ratio analysis cannot be achieved by the mere preparationof financial statement.Ratio analysis helps to appraise the firm in terms of their profitability &efficiency of performance, either individually or in relation to those of other firmsin the same industry. The process of this appraisal is not complete until the ratioso computed can be compared with something, as the ratio all by them do notmean anything. This comparison may be in the form of intra firm comparison,inter firm comparison or comparison with standard ratios. Thus proper comparison of ratios may reveal where a firm is placed as compared with earlier period or in comparison with the other firms in the same industry.Ratio analysis is one of the best possible techniques available to themanagement to impart the basic functions like planning & control. As the futureis closely related to the immediate past, ratio calculated on the basis of historical financial statements may be of good assistance to predict the future.Ratio analysis also helps to locate & point out the various areas, which need themanagement attention in order to improve the situation. As the ratio analysis is concerned with all the aspect of a firms financialanalysis i.e. liquidity, solvency, activity, profitability & overall performance, itenables the interested persons to know the financial & operationalcharacteristics of an organisation & take the suitable decision