Example of Financial Ratio Analysis
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 demand. 3) Inventory Turnover Ratio-It is a ratio showing how many times a company’s inventory is sold and replaced over a period. The days in the period can then be divided by the inventory turnover formula to calculate the days it takes to sell the inventory on hand or “Inventory turnover days” Sales may be substituted with COGS because sales are recorded at market value while inventories are usually recorded at cost. Average inventory may be used instead of the ending inventory level to minimize seasonal factors. 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