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Financial Ratio Analysis

576 words - 3 pages

Interpretation of the Ratios
1) Current Ratio-It is a test of solvency or of short-term financial strength of a concern. It is an index of working capital and shows the ability of the concern to meet its obligations and also the capacity to carry on effective operations. Generally, if current assets are twice that of current liabilities, the concern’s working capital position is considered to be satisfactory.
2) Quick Ratio-It shows the amount of cash available to meet immediate payments. Stock-in –trade is deducted from current assets because it is not considered that stock will supply cash as readily as debtors or bills receivable. Bank overdraft is deducted from current liabilities as it is normally considered to be a simple particular way of financing an enterprise and as such is not considered liable to be called in on ...view middle of the document...

The ratio should be compared against industry averages. A low turnover implies poor sales and therefore excess inventory. A high ratio implies either strong sales or ineffective buying.
4) Debt-Equity Ratio-This ratio compares external liabilities with internal liabilities. The interpretation of this ratio depends upon the financial and business policies of the organization.
5) Debt-Asset Ratio-It indicates what proportion of the company’s assets are being financed through debt. It is similar to the debt-equity ratio. A ratio of less than 1 implies that a majority of assets are financed through equity , above 1 means they are financed more by debt.
7) Gross Profit Ratio Margin-It is a ratio of the gross profits earned to the net sales or turnover. It plays an important role in the trading results of the business enterprise.
8) Net Profit Ratio-It shows what portion of the sales is left to the proprietors after all costs, charges and expenses have been deducted. It is useful to proprietors as it helps in cost control and sales promotion.
9) Return on Equity-It shows the earning power of the proprietor’s funds invested in the business and is therefore of practical interest to the proprietors. It enables the earning capacity of the enterprise to be contrasted with the earning capacity of other investments. It gives an idea as to whether adequate returns are being achieved for the risks has.
10) Assets Turnover ratio-It measures a firm’s efficiency at using its assets in generating sales or revenue-the higher the number the better. It also indicates pricing strategy. Companies with low profit margins tend to have high asset turnover while those with high profit margins have low asset turnover.
11) Return on Capital employed-indicates the efficiency and profitability of a company’s capital investments. ROCE should always be higher than the rate at which the company borrowings; otherwise any increase in borrowing will reduce shareholder’s earnings.

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