Resources | Subject Notes | Accounting
This section focuses on interpreting key financial ratios and using them to make recommendations for improving a company's profitability and working capital management. We will cover various ratio categories, their calculations, and how to analyze their implications.
Profitability ratios measure a company's ability to generate profit relative to its revenue, assets, or equity. Analyzing these ratios helps assess how effectively a company is managing its operations and controlling costs.
Formula: $$ \text{Gross Profit Margin} = \frac{\text{Gross Profit}}{\text{Revenue}} \times 100 $$
Interpretation: A higher gross profit margin indicates that a company is efficiently managing its direct costs of production. It shows how much revenue is left after deducting the cost of goods sold.
Recommendations:
Formula: $$ \text{Net Profit Margin} = \frac{\text{Net Profit}}{\text{Revenue}} \times 100 $$
Interpretation: This ratio measures the percentage of revenue remaining after all expenses, including operating costs, interest, and taxes, have been deducted. It's a comprehensive measure of profitability.
Recommendations:
Formula: $$ \text{ROCE} = \frac{\text{Net Profit}}{\text{Capital Employed}} \times 100 $$
Where: Capital Employed = Total Assets - Current Liabilities
Interpretation: ROCE measures how efficiently a company is using its capital to generate profit. A higher ROCE is generally preferred.
Recommendations:
Liquidity ratios assess a company's ability to meet its short-term financial obligations. They indicate whether a company has sufficient liquid assets to cover its current liabilities.
Formula: $$ \text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}} $$
Interpretation: A current ratio of 2 or higher is generally considered healthy. It indicates that the company has $2 of current assets for every $1 of current liabilities.
Recommendations:
Formula: $$ \text{Quick Ratio} = \frac{\text{Current Assets} - \text{Inventory}}{\text{Current Liabilities}} $$
Interpretation: This ratio is a more conservative measure of liquidity than the current ratio, as it excludes inventory (which may not be easily converted to cash). A quick ratio of 1 or higher is generally considered acceptable.
Recommendations:
Solvency ratios evaluate a company's ability to meet its long-term financial obligations. They assess the company's financial structure and its reliance on debt.
Formula: $$ \text{Debt-to-Equity Ratio} = \frac{\text{Total Debt}}{\text{Shareholders' Equity}} $$
Interpretation: A higher debt-to-equity ratio indicates that the company is financing a larger portion of its assets with debt. A very high ratio can indicate financial risk.
Recommendations:
Formula: $$ \text{Financial Leverage Ratio} = \frac{\text{Total Assets}}{\text{Shareholders' Equity}} $$
Interpretation: This ratio measures the extent to which a company uses debt to finance its assets. A higher ratio indicates greater financial leverage and higher financial risk.
Recommendations:
Activity ratios measure how efficiently a company is using its assets to generate sales.
Formula: $$ \text{Inventory Turnover Ratio} = \frac{\text{Cost of Goods Sold}}{\text{Average Inventory}} $$
Interpretation: A higher inventory turnover ratio indicates that a company is selling its inventory quickly. A low ratio may suggest overstocking or slow-moving inventory.
Recommendations:
Formula: $$ \text{Receivables Turnover Ratio} = \frac{\text{Revenue}}{\text{Average Accounts Receivable}} $$
Interpretation: A higher receivables turnover ratio indicates that a company is collecting its receivables quickly. A low ratio may suggest problems with credit policies or collection efforts.
Recommendations:
Formula: $$ \text{Fixed Asset Turnover Ratio} = \frac{\text{Revenue}}{\text{Average Fixed Assets}} $$
Interpretation: This ratio measures how efficiently a company is using its fixed assets to generate revenue. A higher ratio indicates better asset utilization.
Recommendations:
| Ratio | Formula | Interpretation | Recommendations |
|---|---|---|---|
| Gross Profit Margin | $$ \frac{\text{Gross Profit}}{\text{Revenue}} \times 100 $$ | Efficiency of production and cost control. | Negotiate supplier prices, improve production efficiency, adjust pricing. |
| Net Profit Margin | $$ \frac{\text{Net Profit}}{\text{Revenue}} \times 100 $$ | Overall profitability. | Control operating expenses, reduce interest, optimize tax planning. |
| ROCE | $$ \frac{\text{Net Profit}}{\text{Capital Employed}} \times 100 $$ | Efficiency of capital utilization. | Invest in high-return assets, improve asset utilization, reduce capital employed. |
| Current Ratio | $$ \frac{\text{Current Assets}}{\text{Current Liabilities}} $$ | Ability to meet short-term obligations. | Improve cash collection, reduce inventory, negotiate extended payment terms. |
| Quick Ratio | $$ \frac{\text{Current Assets} - \text{Inventory}}{\text{Current Liabilities}} $$ | More conservative measure of short-term liquidity. | Similar to current ratio, with emphasis on inventory management. |
| Debt-to-Equity Ratio | $$ \frac{\text{Total Debt}}{\text{Shareholders' Equity}} $$ | Level of financial leverage and risk. | Reduce debt, improve profitability. |
| Financial Leverage Ratio | $$ \frac{\text{Total Assets}}{\text{Shareholders' Equity}} $$ | Extent of debt financing. | Reduce debt, improve profitability. |
| Inventory Turnover Ratio | $$ \frac{\text{Cost of Goods Sold}}{\text{Average Inventory}} $$ | Efficiency of inventory management. | Improve inventory management, offer discounts, improve demand forecasting. |
| Receivables Turnover Ratio | $$ \frac{\text{Revenue}}{\text{Average Accounts Receivable}} $$ | Efficiency of credit and collection policies. | Improve credit policies, offer incentives for early payment, implement efficient collection procedures. |
| Fixed Asset Turnover Ratio | $$ \frac{\text{Revenue}}{\text{Average Fixed Assets}} $$ | Efficiency of fixed asset utilization. | Invest in new technology, optimize asset utilization. |