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RATIO ANALYSIS
Accounting ratios express figures in the financial statement in terms of each other.
RATIO ANALYSIS compares ratios of the business over the years(trend analysis) or across the industry to assess its strengths and weaknesses (interfirm comparison).
Ratios can be divided into four main types:
Profitability ratios show how successfully the business is trading and managing its expenses Liquidity/Solvency : ability of the business to settle its debts in the short term Gearing: how much indebted is the business Investment: how the business is faring in the stock market – how market prices for a share reflect company’s performance
A firm will have different categories of users of accounts e.g. shareholders, creditors, management, potential investors. Each user group will be interested in specific ratios as shown below:
Examples of parties with an immediate interest Type of ratio
Potential suppliers of goods on credit; lenders, e.g. bank managers and debenture holders; management
Liquidity
Shareholders( actual and potential); potential take-over bidders; management ; competitive firm; tax authorities; employees
Profitability and use of assets
Shareholders, creditors, lenders Gearing
Shareholders( actual and potential); potential take-over bidders; management Investment
USES OF RATIOS
Ratios are, therefore, used to enable comparisons to be made:
to compare the performance of the business with previous years. to compare the actual performance of the business with the budgeted or planned
performance to compare results with the performance of similar businesses.
It can be used by banks as a measure to grant or deny loans
Advantages of Ratio Analysis
Ratio analysis is a tool or a technique through which one can do the analysis of the financial statements of the company. There are many advantages of ratio analysis:1. Liquidity ratio can be helpful in measuring the liquidity position of the company that is whether a company will able to meet the obligations as and when they arise.2. Since ratio is a simplified figure of complex financial statements it can be easily understood by a person who does not have the accounting knowledge.
3. The various profitability ratios help in judging the operation efficiency of the company and also whether or not company using the resources judiciously.
4. With the help of ratios, it is easy to make comparison of a company with other companies in the same industry and determine the position of the company with respect to its competitors.
5. With the help of ratio analysis one can do trend analysis that is whetherthe financial position of the company is improving or getting worse over the years.
6. As ratios are easy to understand it becomes easy for a company to communicate the ratios to those who are interested in the financial performance of the company.
Limitations of ratio analysis
Though ratio analysis is an important tool for analyzing the financial statements of the company and has many advantages, however it has certain limitations. Let’s look at some of the limitations of the ratio analysis –1. While ratio analysis can be great for comparison between companies, however if there is only one company then ratio analysis can be misleading.
2. Since ratio analysis is done from the data in the financial statements like profit and loss and balance sheet, in case of any mistakes in those financial statements will reflect in the ratios also.3. Since Ratios are easy to manipulate they are misused by managers for window dressing; window dressing refers to presenting of better picture of the company than what it is.4. Ratio analysis does not take into account the qualitative factors; it only presents the figures as they are. So for example it may possible that company may have higher current ratio indicating that liquidity position of the company is good, however if large portion of those current asset includes inventory then it does not mean a sound liquidity position.5. Ratios are not same for everybody that is different people have different perception regarding the ratios. So a current ratio of 2:1 may be good for some people, however some people may think it is not adequate.
Types of ratios
Profitability ratios: A class of financial ratios that are used to assess a business's ability to generate earnings as compared to its expenses and other relevant costs incurred during a specific period of time. For most of these ratios, having a higher value relative to a competitor's ratio or the same ratio from a previous period is indicative that the company is doing well.
Solvency ratios: A class of financial ratios that is used to determine a company's ability to pay off its short-terms debts obligations. Generally, the higher the value of the ratio, the larger the margin of safety that the company possesses to cover short-term debts.
Debt and Gearing ratios: ratios which show the extent to which the long term funding of the business is provided from outside sources.
Investment ratios: a wide array of ratios that can be used by investors to estimate the attractiveness of a potential or existing investment and get an idea of its valuation.
PROFITABILITY RATIOS
(i) Gross Profit Ratio (margin) (also known as Gross Profit percentage) = Gross Profit × 100
Net Sales/Revenue
Mark up = Gross Profit × 100 Cost of Sales
Significance:
This ratio shows the business's ability consistently to control its production costs or to manage the margins its makes on products its buys and sells..
Causes/reasons of increase or decrease in gross profit ratio:
INCREASE: better
It should be observed that an increase in the GP ratio may be due to the following factors.
1. Increase in the selling price of goods sold without any corresponding increase in the cost of goods sold.2. Decrease in cost of goods sold without corresponding decrease in selling price.3. Omission of purchase invoices from accounts.4. Under valuation of opening stock or overvaluation of closing stock.
On the other hand, the decrease in the gross profit ratio may be due to the following factors.
DECREASE : worse
1. Decrease in the selling price of goods, without corresponding decrease in the cost of goods sold.2. Increase in the cost of goods sold without any increase in selling price.3. Unfavorable purchasing or markup policies.4. Inability of management to improve sales volume, or omission of sales.5. Over valuation of opening stock or under valuation of closing stock
(ii) Net Profit Ratio (also known as Net Profit percentage) = Net profit before interest and tax × 100Net Sales Revenue
can also be expressed as Net Profit(after interest) Net Sales/Revenue
[Uses NPBI – Net Profit before interest, i.e. add back interest]Significance:
NP ratio is used to measure the overall profitability and hence it is very useful to proprietors. The ratio is very useful as if the net profit is not sufficient, the firm shall not be able to achieve a satisfactory return on its investment.
This ratio also indicates the firm's capacity to face adverse economic conditions such as price competition, low demand, etc. Obviously, higher the ratio the better is the profitability. But while interpreting the ratio it should be kept in mind that the performance of profits also be seen in relation to investments or capital of the firm and not only in relation to sales.
REASONS FOR INCREASE/DECREASE
Increase: better Efficient control of expenses
Decrease: worse Inefficient control of expenses Increase in advertising campaign to boost up sales
(iii) Return on Capital Employed = NPBI × 100Capital Employed
[Capital Employed = Issued Shares + Reserves + Non-Current Liabilities]
The prime objective of making investments in any business is to obtain satisfactory return on capital invested. Hence, the return on capital employed is used as a measure of success of a business in realizing this objective.
Return on capital employed establishes the relationship between the profit and the capital employed. It indicates the percentage of return on capital employed in the business and it can be used to show the overall profitability and efficiency of the business.
Definition of Capital Employed:
Capital employed and operating profits are the main items. Capital employed may be defined in a number of ways. However, two widely accepted definitions are "gross capital employed" and "net capital employed". Gross capital employed usually means the total assets, fixed as well as current, used in business, while net capital employed refers to total assets minus liabilities. On the other hand, it refers to total of capital, capital reserves, revenue reserves (including profit and loss account balance), debentures and long term loans.
Significance of Return on Capital Employed Ratio:
Return on capital employed ratio is considered to be the best measure of profitability in order to assess the overall performance of the business. It indicates how well the management has used the investment made by owners and creditors into the business. It is commonly used as a basis for various managerial decisions. As the primary objective of business is to earn profit, higher the return on capital employed, the more efficient the firm is in using its funds. The ratio can be found for a number of years so as to find a trend as to whether the profitability of the company is improving or otherwise
INCREASE : better Increase in profits Decrease in capital employed with profits level maintained
DECREASE: worse Decrease in profitability Increase in capital but profits level same
(iv) Return on Equity = Net Profit after Preference Dividends × 100 Equity
[Equity = Issued Ordinary Shares + Reserves]
Significance:
This ratio is more meaningful to the equity shareholders who are interested to know profits earned by the company and those profits which can be made available to pay dividend As the ratio reveals how well the resources of the firm are being used, higher the ratio, better are the results. The inter firm comparison of this ratio determines whether the investments in the firm are attractive or not as the investors would like to invest only where the return is higher.s to them
(v) Return on Total Assets = NPBI × 100 Total Assets
[Total Assets = Non-Current Assets + Current Assets]
Significance: this ratio shows the % return on total assets used in business
A ratio that measures a company's earnings before interest and taxes (EBIT) against its total net assets. The ratio is considered an indicator of how effectively a company is using its assets to generate earnings before contractual obligations must be paid.
The greater a company's earnings in proportion to its assets (and the greater the coefficient from this calculation), the more effectively that company is said to be using its assets
(vi) Operating expenses to Revenue Ratio = Operating Expenses × 100 Revenue
A ratio that shows the efficiency of a company's management by comparing operating expense to net sales. The smaller the ratio, the greater the organization's ability to generate profit if revenues decrease. When using this ratio, however, investors should be aware that
it doesn't take debt repayment or expansion into account.
(vii) Non-Current Asset Turnover = Net Sales RevenueTotal Net Book Value of Non Current Assets
It indicates how well the business is using its fixed assets to generate sales.
Generally speaking, the higher the ratio, the better, because a high ratio indicates the business has less money tied up in fixed assets for
each unit of currency of sales revenue. A declining ratio may indicate that the business is over-invested in plant, equipment, or other fixed
assets.
LIQUIDITY RATIOS
Liquidity is a business firm's ability to repay its short-term debts and obligations on time. Short-term usually means one year or less.
(1) CURRENT RATIO
Current ratio may be defined as the relationship between current assets and current liabilities. This ratio is also known as "working capital ratio". It is a measure of general liquidity and is most widely used to make the analysis for short term financial position or liquidity of a firm. It is calculated by dividing the total of the current assets by total of the current liabilities.
Formula:
Following formula is used to calculate current ratio:
Current Ratio = Current Assets / Current Liabilities
Or
Current Assets : Current Liabilities
Components:
The two basic components of this ratio are current assets and current liabilities. Current assets include cash and those assets which can be easily converted into cash within a short period of time, generally, one year, such as inventory, sundry debtors,prepaid expenses..
Current liabilities are those obligations which are payable within a short period of tie generally one year and include outstanding expenses, bills payable, sundry creditors, bank overdraft, accrued expenses, short term advances, income tax payable, etc.
This ratio is a general and quick measure of liquidity of a firm. It represents the margin of safety or cushion available to the creditors. It is an index of the firms financial stability. It is also an index of technical solvency and an index of the strength of working capital.
A relatively high current ratio is an indication that the firm is liquid and has the ability to pay its current obligations in time and when they become due. On the other hand, a relatively low current ratio represents that the liquidity position of the firm is not good and the firm shall not be able to pay its current liabilities in time without facing difficulties. An increase in the current ratio represents improvement in the liquidity position of the firm while a decrease in the current ratio represents that there has been a deterioration in the liquidity position of the firm. A ratio equal to or near 2 : 1 is considered as a standard or normal or satisfactory. The idea of having double the current assets as compared to current liabilities is to provide for the delays and losses in the realization of current assets. However, the rule of 2 :1 should not be blindly used while making interpretation of the ratio. Firms having less than 2 : 1 ratio may be having a better liquidity than even firms having more than 2 : 1 ratio. This is because of the reason that current ratio measures the quantity of the current assets and not the quality of the current assets. If a firm's current assets include debtors which are not recoverable or stocks which are slow-moving or obsolete, the current ratio may be high but it does not represent a good liquidity position.
Limitations of Current Ratio:
This ratio is measure of liquidity and should be used very carefully because it suffers from many limitations. It is, therefore, suggested that it should not be used as the sole index of short term solvency.
1. It is crude ratio because it measure only the quantity and not the quality of the current assets.2. Even if the ratio is favorable, the firm may be in financial trouble, because of more stock and work in process which is not
easily convertible into cash, and, therefore firm may have less cash to pay off current liabilities.3. Valuation of current assets and window dressing is another problem. This ratio can be very easily manipulated by overvaluing
the current assets. An equal increase in both current assets and current liabilities would decrease the ratio and similarly equal decrease in current assets and current liabilities would increase current ratio.
(2) Liquid or Liquidity or Acid Test or Quick Ratio:
Liquid ratio is also termed as "Liquidity Ratio", "Acid Test Ratio" or "Quick Ratio". It is the ratio of liquid assets to current liabilities. The true liquidity refers to the ability of a firm to pay its short term obligations as and when they become due.
Components:
The two components of liquid ratio (acid test ratio or quick ratio) are liquid assets and liquid liabilities. Liquid assets normally include cash, bank and trade receivables. In other words they are current assets minus inventories (stock) . Inventories cannot be termed as liquid assets because it cannot be converted into cash immediately without a loss of value. Similarly, Liquid liabilities means current liabilities i.e., sundry creditors, bills payable, outstanding expenses, short term advances, income tax payable, and bank overdraft (only if payable on demand).
Formula of Liquidity Ratio / Acid Test Ratio:
[Liquid Ratio = Liquid Assets / Current Liabilities]
Example:
From the following information of a company, calculate liquid ratio. Cash $180; Debtors $1,420; inventory $1,800; Bills payable $270; Creditors $500 Accrued expenses $150; Tax payable $750.
Liquid Assets = 180 + 1,420 = 1.600
Current Liabilities = 270 + 500 + 150 + 750 = 1,670
Liquid Ratio = 1,600 / 1,670
= 0.958 : 1
The quick ratio/acid test ratio is very useful in measuring the liquidity position of a firm. It measures the firm's capacity to pay off current obligations immediately and is more rigorous test of liquidity than the current ratio. It is used as a complementary ratio to the current ratio. Liquid ratio is more rigorous test of liquidity than the current ratio because it eliminates inventories as a part of current assets. Usually a high liquid ratios an indication that the firm is liquid and has the ability to meet its current or liquid liabilities in time and on the other hand a low liquidity ratio represents that the firm's liquidity position is not good. As a convention, generally, a quick ratio of "one to one" (1:1) is considered to be satisfactory.
Although liquidity ratio is more rigorous test of liquidity than the current ratio , yet it should be used cautiously and 1:1 standard should not be used blindly. A liquid ratio of 1:1 does not necessarily mean satisfactory liquidity position of the firm if all the debtors cannot be realized and cash is needed immediately to meet the current obligations. In the same manner, a low liquid ratio does not necessarily mean a bad liquidity position as inventories are not absolutely non-liquid. Hence, a firm having a high liquidity ratio may not have a satisfactory liquidity position if it has slow-paying debtors. On the other hand, A firm having a low liquid ratio may have a good liquidity position if it has a fast moving inventories. Though this ratio is definitely an improvement over current ratio, the interpretation of this ratio also suffers from the same limitations as of current ratio .
(3) Inventory turnover
Definition:
Stock turn over ratio and inventory turn over ratio are the same. This ratio is a relationship between the cost of goods sold during a particular period of time and the cost of average inventory during a particular period. It is expressed in number of times. Stock turn over ratio/Inventory turn over ratio indicates the number of time the stock has been turned over during the period and evaluates the efficiency with which a firm is able to manage its inventory. This ratio indicates whether investment in stock is within proper limit or not.
Components of the Ratio:
Average inventory and cost of goods sold are the two elements of this ratio. Average inventory is calculated by adding the stock in the beginning and at the end of the period and dividing it by two. In case of monthly balances of stock, all the monthly balances are added and the total is divided by the number of months for which the average is calculated.
Formula of Stock Turnover/Inventory Turnover Ratio:
The ratio is calculated by dividing the cost of goods sold by the amount of average stock atcost.
Inventory Turnover Ratio = Cost of goods sold / Average inventory at cost
Example:
The cost of goods sold is $500,000. The opening stock is $40,000 and the closing stock is $60,000 (at cost).
Calculate inventory turnover ratio
Calculation:
Inventory Turnover Ratio (ITR) = 500,000 / 50,000*
= 10 times
This means that an average one dollar invested in stock will turn into ten times in sales
*($40,000 + $60,000) / 2= $50,000
Significance of ITR:
Inventory turnover ratio measures the velocity of conversion of stock into sales. Usually a high inventory turnover/stock velocity indicates efficient management of inventory because more frequently the stocks are sold, the lesser amount of money is required to finance the inventory. A low inventory turnover ratio indicates an inefficient management of inventory. A low inventory turnover implies over-investment in inventories, dull business, poor quality of goods, stock accumulation, accumulation of obsolete and slow moving goods and low profits as compared to total investment. The inventory turnover ratio is also an index of profitability, where a high ratio signifies more profit, a low ratio signifies low profit. Sometimes, a high inventory turnover ratio may not be accompanied by relatively a high profits. Similarly a high turnover ratio may be due to under-investment in inventories.
It may also be mentioned here that there are no rule of thumb or standard for interpreting the inventory turnover ratio. The norms may be different for different firms depending upon the nature of industry and business conditions. However the study of the comparative or trend analysis of inventory turnover is still useful for financial analysis.
Rate of inventory turnover
ROI = Average inventory/ Cost of sales x 365
It shows the average number of days taken to turnover stock. The lower the better because this is an indication that stock is moving faster leading to higher profits and better liquidity position. If it increases it is worse.
(4) Average Collection Period Ratio/ Dectors collection period
Definition:
The Debtors/Receivable Turnover ratio when calculated in terms of days is known as Average Collection Period or Debtors Collection Period Ratio.
The average collection period ratio represents the average number of days for which a firm has to wait before its debtors are converted into cash.
Formula of Average Collection Period:
Following formula is used to calculate average collection period:
Trade Debtors / Net Credit Sales x 365 = x days
Trade debtors/ Net Credit Sales x 52 = x weeks
Example:
Credit sales $25,000; Return inwards $1,000; Debtors $4,000.
Calculate average collection period.
Calculation:
Average collection period can be calculated as follows:
Average Collection Period = (Trade Debtors × No. of Working Days) / Net Credit Sales
4,000/ 24,000 x 360 = 60 Days
**For calculating this ratio usually the number of working days in a year are assumed to be 360.
Significance of the Ratio:
This ratio measures the quality of debtors. A short collection period implies prompt payment by debtors ( efficient credit control). It reduces the chances of bad debts. Similarly, a longer collection period implies too liberal and inefficient credit collection performance. ( poor credit control)It is difficult to provide a standard collection period of debtors.
( 5) Creditors Days:
Definition and Explanation:
This ratio is similar to the debtors collection period. It compares creditors with the total credit purchases.
It signifies the credit period enjoyed by the firm in paying creditors. Average payment period ratio gives the average credit period enjoyed from the creditors. It can be calculated using the following formula:
Average Payment Period = (Trade Creditors / Net Credit Purchase) x 365
(In case information about credit purchase is not available total purchases may be assumed to be credit purchase.)
Significance of the Ratio:
The average payment period ratio represents the number of days by the firm to pay its creditors. A lower credit period ratio signifies that the creditors are being paid promptly. This situation enhances the credit worthiness of the company. However a very favorable ratio to this effect also shows that the business is not taking the full advantage of credit facilities allowed by the creditors.
(6) WORKING CAPITAL CYCLE(WCC) / CASH OPERATING CYCLE
This ratio expresses the length of time (in days) that a company uses to sell inventory, collect receivables and pay its accounts payable. The WCC measures the number of days a company's cash is tied up in the the production and sales process of its operations and the benefit it gets from payment terms from its creditors. The shorter this cycle, the more liquid the company's working capital position is. The WCC is also known as the "cash" or "operating" cycle.
Formula: WCC = Stock turnover (days) + Debtors days – Creditors Days
Example:
Stockturnover 280 days
Debtors days +58 days
Creditors days -63 days
Cash Operating cycle 275 days
Commentary:
The cash conversion cycle is vital for two reasons.
It's an indicator of the company's efficiency in managing its important working capital assets; It provides a clear view of a company's ability to pay off its current liabilities.
It does this by looking at how quickly the company turns its inventory into sales, and its sales into cash, which is then used to pay its suppliers for goods and services. Again, while the quick and current ratios are more often mentioned in financial reporting, investors would be well advised to measure true liquidity by paying attention to a company's cash conversion cycle.
The longer the duration of inventory on hand and of the collection of receivables, coupled with a shorter duration for payments to a company's suppliers, means that cash is being tied up in inventory and receivables and used more quickly in paying off trade payables. If this circumstance becomes a trend, it will reduce, or squeeze, a company's cash availabilities. Conversely, a positive trend in the cash conversion cycle will add to a company's liquidity.
(7) NET WORKING ASSETS/ REVENUE X 100 = X %
Net working assets = Inventory + trade receivables – trade payables
Expresses net working assets as a percentage of revenue. It shows the efficiency with which trading assets have been used to generate revenue.
(8) Over-trading
Overtrading may occur when a business increases its turnover rapidly with the result that its stock, debtors and creditors also increase but to a level that threatens its liquidity. The business may become insolvent and unable to pay its creditors as they fall due. This may lead to bankruptcy.
(9) INCOME GEARING
= Interest expense/Profit before interest x 100 = x %
Income gearing shows the safety margin for lenders . The higher the % the safer lenders are concerning interest payment. Decrease in the ratio may be indicative of falling profits or rising finance costs thus decreasing the safety margin for lenders.
DEBT RATIOS: CALCULATES THE EXTENT TO WHICH THE COMPANY IS INDEBTED
(a) Debt/ equity ratio = Fixed cost capital/ Equity x 100 = x %
Equity = ordinary share capital + reserves
If ratio > 100 % highly geared
If = 100 % neutral gearing
If < 100% low gearing
(b) Gearing ratio = Fixed cost capital/ Total capital x 100 = x %
Total capital = share capital + reserves + non current liabilities
Fixed cost capital = preference share capital + non current liabilities
If ratio > 50 % highly geared
If = 50 % neutral gearing
If < 50% low gearing
High gearing is an indication of increased indebtedness thus leading to higher risk for shareholders . Shareholders run the risk of being paid lower or no dividend in times of falling profits.
Low gearing implies lower risk since shareholders will enjoy higher dividend.
INVESTMENT RATIOS
(i) Earnings per share = Net profit after interest, tax and preference dividends/ no of issued ordinary shares = $ x
Earnings per share shows the amount earned by each ordinary share after deduction of finance costs, tax charges and preference dividend. An increase is better since it indicates increasing profits / higher earnings. Decrease is worse.
The earnings per share is a good measure of profitability and when compared with EPS of similar companies, it gives a view of the comparative earnings or earnings power of the firm. EPS ratio calculated for a number of years indicates whether or not the earning power of the company has increased.
(ii) Price Earnings ratio = market price per share/ earnings per share = x
This ratio calculates the number of times the price being paid for the shares on the market exceeds the earnings per share. The ratio is a measure of the confidence in the ability of the firm to maintain its earnings in future. The higher the ratio the better since it implies that investors are confident that the company will generate high earnings in future.
(iii) Dividend yield = Div per share/ Market price per share x 100
This ratio shows the percentage return to the shareholder on the amount invested in the business. Increase is better and indicates higher return whereas decrease is worse.
(iv) Dividend cover = Profit available to pay ordinary dividend/ Ordinary dividend paid = x times
: shows the no of times profit attributable to ordinary shareholders covers ordinary dividend paid. Increase is better and is indicative of higher profits. Decrease is worse and indicates falling profits.
(v) Dividend per share = Ordinary dividend paid/ Number of issued ordinary shares
Shows the dividend paid per share. Increase indicates higher profitability. Potential investors will be encouraged to buy shares.
Cash Flow RatiosOne of the most frequently overlooked financial statements is the cash flow statement which is the optimum resource for testing a company's liquidity. It normally plays third fiddle to the income statement and the balance sheet.Financial ratios that relate to statement of cash flows were slow in being developed. This was mainly due to the fact that financial ratios traditionally based on income statement and balance sheet items. This was the normal way to approach financial analysis until the cash flow statement becomes a required part of published financial statements. The cash flow ratios like other ratios are used to understand financial statements. Higher levels of cash flow indicate improved cash earnings and liquidity. Although not widely used, cash flow ratios can be useful in determining the adequacy of cash and cash equivalents.
Uses and Benefits of Cash Flow Ratios Cash flow ratios are more reliable indicators of liquidity than balance sheet or income statement ratios including the current or
quick ratio. By using cash flow ratios the impact of different accounting conventions is eliminated.
The liquidity ratios measure how liquid a company was on a single date in the past, cash flow ratios can be used to evaluate how much cash a company generated over a period of time.
Lenders, investors and credit rating agencies have long used cash flow ratios to evaluate risk, but auditors have been slow to use them.
They reduce risk for lenders and investors and enable owners, managers and consultants to increase productivity and business profits.
Some cash flow ratios compare the resources a company can muster with its short-term commitments. Other cash flow ratios measure a company’s ability to meet ongoing financial and operational commitments. Auditors can use the insights uncovered by cash flow ratios to spotlight potential problem areas, thus helping them plan their
audits more effectively.
Cash flow MarginCash flow margin also called operating cash flow to sales or Cash flow efficiency of sales measures the operational cash flow generated by each currency unit of net sales. Cash flows from operations are related to sales to evaluate earnings quality. A higher cash flow margin especially when compared with net profit margin typically indicates higher earnings quality. It measures the ability of a firm to translate its sales into real cash.We know that it is cash, not accrual based earnings that a company needs to service debts, pay its expenses and make investment in new capital assets. The cash flow margin helps us to determine the ability of a company to convert its sales into cash. Which ratio is better?Higher Cash flow margin indicates improved cash earnings and liquidity as earnings are of higher quality if they are backed up by cash.Lower or negative cash flow margin, the company will have to rely on cash reserves or take on more debt as they continue the business. The slang term "burn-rate" is often used to describe a company operating with negative cash flows because the company is "burning" through its cash reserves.
Formula
Cash flow margin =OperatingCash FlowSales(Revenue)
×100
In 20X5 company had a cash flow margin that was greater than its operating profit margin which indicates a strongly positive generation of cash. The performance in 20X5 reveals a solid improvement over 20X4 when the company failed to generate cash from operations and had a negative cash flow margin.
Cash interest coverA company's ability to pay interest due to its creditors is often measured using interest cover based on accounting profits, which may not accurately reflect the ability of firm to handle its interest payments out of operating cash flows. Cash interest cover uses operating cash flow rather than operating profit (profit before interest and tax) and indicates the cash actually available to meet interest charges. A ratio of less than 1 indicates insufficient cash flow is being generated to meet current interest payments.
Cash interest cover avoids some of the weaknesses of the income statement based interest cover, but has its own problems. For example, if interest is incurred but the actual payment is delayed, then the cash interest cover may appear much better or worse than the real picture due to this lumpiness. Cash interest cover is probably best used as a supplement to interest cover rather than a substitute.
Formula
Cash interest cover =OperatingCashFlowInterest Expense Paid
×100
Which trend is better?A higher Cash interest cover is better as it ensures that business is a going concern and has adequate liquid resources to pay off fixed interest charges.
Cash dividend coverCash dividend cover is similar to dividend cover. It is simply how many times dividends could have been paid out of cash flow rather than profits. As we know that to propose and pay ordinary dividends to ordinary shareholders both profits and cash are needed so this ratio evaluates the ability of a firm to cover dividends payments after meeting interest, tax and preference dividends payments. This ratio like cash interest cover is probably best used as a supplement to dividends cover rather than a substitute.
Formula
Cash dividend cover =OperatingCash Flowsless Interest ,Tax∧Preferencedividends
Ordinary ShareholdersDividends×100
Which trend is better?The higher the cash dividend cover ratio, the better the firm’s ability to pay cash dividends. The lower cash dividend cover ratio on the hand may indicate liquidity problems for the company in making payment for ordinary dividends.
Operating cash flow ratioThe operating cash flow ratio measures a company's ability to pay its short term liabilities from the cash flow generated from its operations. The purpose of this ratio is to assess whether or not a company's operations are generating enough cash flow to cover its current liabilities. Operating cash flow can be used as a check on the quality of a company's earnings. It's arguably a better measure of a business's performance than profits; because a company can show positive net earnings and have negative operating cash flows so may not be able to pay its debts. In that case it may be using aggressive accounting techniques.In some ways, it's even more important to assess whether or not a company is generating enough cash to repay its current debts. If the company defaults on these obligations, then the risk of bankruptcy increases, as does the company's risk of having its assets seized by creditors. If a company cannot meet its current debt obligations, then it's not going to be easy for it to borrow additional funds. Even in the event that it can borrow funds, the associated terms are not likely to be very favorable.
Formula
Operating cash flow ratio =OperatingCash FlowCurrent Liabilities
×100The numerator of this fraction, which is found right on the cash flow statement through a series of adjustments to net income for non-cash items and changes in working capital. The denominator takes into account all current liabilities found on the balance sheet.The current asset ratio and others based on balance sheet numbers gauge liquidity as at the balance sheet date, whereas the operating cashflow ratio uses the cash generated over an accounting period.
Which Trend is better?Generally, a higher ratio is preferred as it indicates that the company has plenty of cash flow to settle short term obligations. As with all liquidity ratios, sector norms and the peculiarities of each business need to be taken into consideration. A low ratio could be an indication of financial distress in the future as it means that the company has generated less cash over the year than it needs to pay off short term liabilities as at the year end. This may signal a need to find other sources to fund company’s operations or slow the rate at which it is spending its cash.
LIMITATIONS OF RATIOS
Limitations of Financial RatiosThere are some important limitations of financial ratios that analysts should be conscious of:
Many large firms operate different divisions in different industries. For these companies it is difficult to find a meaningful set of industry-average ratios.
Inflation may have badly distorted a company's balance sheet. In this case, profits will also be affected. Thus a ratio analysis of one company over time or a comparative analysis of companies of different ages must be interpreted with judgment.
Seasonal factors can also distort ratio analysis. Understanding seasonal factors that affect a business can reduce the chance of misinterpretation. For example, a retailer's inventory may be high in the summer in preparation for the back-to-school season. As a result, the company's accounts payable will be high and its ROA low.
Different accounting practices can distort comparisons even within the same company (leasing versus buying equipment, LIFO versus FIFO, etc.).
It is difficult to generalize about whether a ratio is good or not. A high cash ratio in a historically classified growth company may be interpreted as a good sign, but could also be seen as a sign that the company is no longer a growth company and should command lower valuations.
A company may have some good and some bad ratios, making it difficult to tell if it's a good or weak company.
