financial ratios

• 

Liquidity

• Liquidity is indicated by Current ratio (working capital)

The current ratio

• The current ratio measures :: a business’s ability to pay back its current liabilities with its current assets.
  • Shows the short-term financial stability
• 

Gearing (inverse solvency)

• Gearing ratios inversely determine the firm’s solvency

The debt to equity ratio

?

• The Debt to equity ratio shows the extent to which the firm is relying on debt or outside sources to finance the business.
• (higher gearing = less solvent)
• 

Profitability

• indicates a businesses capacity to use its resources to maximise profits.
• Three profitability ratios are the:
  • gross profit ratio
  • net profit ratio
  • return on equity ratio

gross profit ratio

?

• Shows the percentage of sales revenue that results in gross profit
• i.e. the portion of money from sales that is left after COGS
• (higher = better)
• 

net profit ratio

?

• i.e. the portion of money left after COGS and general expenses
• 

return on equity ratio

?

• shows how effective the funds contributed by the owners have been in generating a profit or a return on investment.
• Comparisons should only be made between businesses within the same industry
• 

Efficiency

• Efficiency refers to the ability of a business to use its resources effectively in ensuring financial stability and profitability of the business.
• Two efficiency ratios are the:
  ?
• Expense ratio
• Accounts receivable ratio

Expense ratio

?

• The expense ratio indicates the amount of sales that are allocated to individual expenses.
• 

Accounts receivable (turnover) ratio

?

• The accounts receivable turnover ratio measures the effectiveness of a business’ credit policy and how efficiently it collects its debts.
• 
  • how many times A/R is collected per year (higher better) ($\ge$ 12 is ideal)
• 
  • 365 / (how many times A/R is collected per year)
  • shows the average days taken to collect A/R
    • (lower better) ($\le$ 30 days is ideal)

comparative ratio analysis

?

• For analysis to be meaningful, comparisons and benchmarks are needed.
• financial ratios are compared to other similar businesses in the market