

Investment
Analysis & Portfolio Management
(FIN630)
VU
Lesson
# 12
FUNDAMENTAL
ANALYSIS Contd...
Ratio
Analysis:
Financial
ratio analysis is a fascinating
topic to study because it can teach us so
much about
accounts
and businesses. When we use
ratio analysis we can work
out how profitable a
business
is, we can tell if it has
enough money to pay its
bills and we can even tell
whether
its
shareholders should be happy.
Ratio
analysis can also help us to check
whether a business is doing
better this year than
it
was
last year; and it can tell us if
our business is doing better
or worse than other
businesses
doing
and selling the same
things.
In
addition to ratio analysis
being part of an accounting and
business studies syllabus, it is a
very
useful thing to know
anyway.
The
overall layout of this
section is as follows: We will begin by
asking the question,
what
do we
want ratio analysis to tell
us? Then, what will we try
to do with it? This is the
most
important
question. The answer to that
question then means we need
to make a list of all of
the
ratios we might use: we will list
them and give the formula
for each of them.
Once
we have discovered all of
the ratios that we can use
we need to know how to
use
them,
who might use them and
what for and how will it
help them to answer the
question
we
asked at the
beginning?
At
this stage we will have an
overall picture of what
ratio analysis is, who
uses it and the
ratios
they need to be able to use
it. All that's left to do
then is to use the ratios;
and we will
do
that step bystep, one by
one.
By
the end of this section we will
have used every ratio
several times and we will be
experts
at
using and understanding what
they tell us.
LIQUIDITY
RATIOS:
1.
The Current
Ratio:
The
current ratio is also known as
the working
capital ratio and is
normally presented as a
real
ratio. The formula to
calculate the current ratio
is;
Current
Ratio = Current Assets /
Current Liabilities
The
ratio is mainly used to give
an idea of the company's
ability to pay back its
shortterm
liabilities
(debt and payables) with its
shortterm assets (cash, inventory,
receivables). The
higher
the current ratio, the
more capable the company is
of paying its obligations. A
ratio
under
1 suggests that the company
would be unable to pay off
its obligations if they
came
due at
that point. While this
shows the company is not in
good financial health, it does
not
necessarily
mean that it will go bankrupt  as there
are many ways to access
financing but
it is
definitely not a good
sign.
83
Investment
Analysis & Portfolio Management
(FIN630)
VU
The
current ratio can give a
sense of the efficiency of a
company's operating cycle or
its
ability
to turn its product into
cash. Companies that have
trouble getting paid on
their
receivables
or have long inventory
turnover can run into
liquidity problems because
they are
unable
to alleviate their obligations.
Because business operations
differ in each
industry,
it is
always more useful to
compare companies within the
same industry.
This
ratio is similar to the
acidtest ratio except that
the acidtest ratio does
not include
inventory
and prepaid as assets that can be
liquidated. The components of
current ratio
(current
assets and current liabilities) can be
used to derive working
capital (difference
between
current assets and current
liabilities). Working capital is
frequently used to
derive
the
working capital ratio, which
is working capital as a ratio of
sales.
The
working capital means the
amount that current assets
exceed the current
liabilities. In
simple
words, it is the difference
current assets and current
liabilities.
Working
Capital = Current Assets
Current Liabilities
Positive
working capital means that
the company is able to pay off its
shortterm
liabilities.
Negative working capital means
that a company currently is unable to
meet its
shortterm
liabilities with its current
assets (cash, accounts receivable and
inventory).
2.
The Acid Test
Ratio:
The
acid test ratio is also known as the
liquid or the quick ratio.
The idea behind this
ratio is
that
stocks are sometimes a problem because
they can be difficult to sell or
use. That is,
even
though a supermarket has
thousands of people walking through
its doors every day,
there
are still items on its
shelves that don't sell as
quickly as the supermarket
would like.
Similarly,
there are some items
that will sell very
well.
Nevertheless,
there are some businesses
whose stocks will sell or be used
slowly and if
those
businesses needed to sell
some of their stocks to try to
cover an emergency,
they
would
be disappointed. Engineering companies can
have their materials in
stock for as
much
as 9 months to a year; a greengrocer
should have his stocks for
no longer than 4 or 5
days  a good
greengrocer anyway.
We'll
look at the acid test
ratio;
Acid
Test Ratio = (Current Assets 
Inventory) / Current
Liabilities
PROFITABILITY
RATIOS:
1.
Gross Profit
Margin:
Gross
Profit Margin = Gross Profit
/ Net Sales * 100
Remember;
Gross
Profit = Sales Cost of Goods
Sold
The
gross profit margin ratio
tells us the profit a
business makes on its cost of
sales, or cost
of
goods sold. It is a very
simple idea and it tells us
how much gross profit per
Rs. 1 of
turnover
our business is
earning.
84
Investment
Analysis & Portfolio Management
(FIN630)
VU
Gross
profit is the profit we earn
before we take off any
administration costs, selling
costs
and so
on. So we should have a much
higher gross profit margin
than net profit
margin.
2.
Operating Margin:
A
ratio used to measure a
company's pricing strategy and
operating efficiency.
Calculated
as:
Operating
Margin = Operating Income /
Net Sales
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.
Operating
margin gives analysts an
idea of how much a company
makes (before interest
and
taxes)
on each dollar of sales.
When looking at operating
margin to determine the
quality of
a
company, it is best to look at
the change in operating margin
over time and to compare
the
company's
yearly or quarterly figures to those of
its competitors. If a company's
margin is
increasing,
it is earning more per rupee of sales.
The higher the margin,
the better it is.
3.
Net Profit
Margin:
Net
Profit Margin = Net Profit /
Net Sales *100
Remember;
Net
Profit = Gross Profit 
Expenses
Why do we
have two versions of this
ratio  one for net profit
and the other for profit
before
interest
and taxation? Well, in some
cases, you will find they
use the term net
profit and in
other
cases, especially published
accounts, they use profit
before interest and taxation.
They
both
mean the same. The net
profit margin ratio tells us
the amount of net profit per
Rs. 1 of
turnover
a business has earned. That
is, after taking account of
the cost of sales,
the
administration
costs, the selling and distributions
costs and all other costs,
the net profit is
the
profit that is left, out of
which they will pay
interest, tax, dividends and so
on.
4.
Earnings per share
(EPS):
The
portion of a company's profit
allocated to each outstanding
share of common
stock.
EPS
serves as an indicator of a company's
profitability. Calculated
as:
Earnings
per Share = Profit Available to
Shareholders / Average common
shares
outstanding
Earnings
per share (EPS) is the profit
attributable to shareholders (after
interest, tax, and
everything
else) divided by the number of
shares in issue. It is the amount of a
company's
profits
that belong to a single
ordinary share.
LEVERAGE
RATIO:
Any
ratio used to calculate the
financial leverage of a company to get an
idea of the
company's
methods of financing or to measure
its ability to meet financial
obligations.
85
Investment
Analysis & Portfolio Management
(FIN630)
VU
A
general term describing a
financial ratio that
compares some form of
owner's equity (or
capital)
to borrowed funds. Gearing is a
measure of financial leverage,
demonstrating the
degree
to which a firm's activities
are funded by owner's funds
versus creditor's
funds.
Leverage =
Long term debt / total
equity
The
higher a company's degree of
leverage, the more the
company is considered risky. As
for
most ratios, an acceptable
level is determined by its
comparison to ratios of companies
in
the same industry. The
best known examples of
gearing ratios include the
debttoequity
ratio
(total debt / total equity),
times interest earned (EBIT
/ total interest), equity
ratio
(equity
/ assets), and debt ratio (total debt /
total assets).
A
company with high gearing
(high leverage) is more
vulnerable to downturns in
the
business
cycle because the company
must continue to service its
debt regardless of how
bad
sales
are. A greater proportion of equity
provides a cushion and is seen as a
measure of
financial
strength.
1.
Interest Coverage
Ratio:
A
ratio used to determine how
easily a company can pay
interest on outstanding debt.
The
ratio
is calculated by dividing a company's
earnings before interest and taxes
(EBIT) of one
period
by the company's interest
expenses of the same
period:
The
interest cover ratio tells
us the safety margin that
the business has in terms of
being able
to meet
its interest obligations.
That is, a high interest
cover ratio means that
the business is
easily
able to meet its interest obligations
from profits. Similarly, a
low value for the
interest
cover
ratio means that the
business is potentially in danger of not
being able to meet its
interest
obligations.
Here's a
reminder of the
formula:
Interest
Coverage Ratio = Earnings before
interest and tax / interest
expense
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