a) Liquidity Ratio:
Liquidity ratios measure a firm's ability to meet its current obligations. These include:
· Current Ratio
Current ratio determines the short term liquidity position of an entity
Current Assets / Current Liabilities
Benchmark Rate:
2:1 for companies
1.5:1 for Banks
If near or above to benchmark rate it favourable for organizations. (Current Assets are more than Current liabilities)
If below to 1 is not favourable for organizations (Current Liabilities are more than Current assets)
· Acid Test Ratio (Quick Ratio)
Acid test ratio determines to see the organization liquidity position by subtracting inventory and prepaid expenses.
Quick Assets / Current Liabilities
Quick Assets - Also known as Liquid Assets. Consists of cash, short-term marketable securities and accounts receivable.
Benchmark Rate:
1:1 for companies
1:1 for Banks
If above to benchmark rate it's favourable for organizations. (Current Assets after subtracting prepayments are more than Current liabilities)
If below to 1 is not favourable for organizations (Current Liabilities are more than Current assets after subtracting prepayments)
Note:-
If it is below 1 it suggest the business has insufficient liquid assets to meet their short term liabilities.
· Working capital
Working capital is the difference of current assets minus current liabilities. This measures the short term solvency position of the company.
Current Assets – Current Liabilities
If Current Assets are more than Current Liabilities then it's favourable for organizations because organizations have positive working capital.
If Current Liabilities are more than Current Assets then it's NOT favourable for organizations because organizations will have Negative working capital.
b) Leverage Ratios
Leverage ratios (also known as Gearing Ratio) measure the degree of protection of suppliers of long term funds. These include:
· Times Interest Earned (Interest Coverage Ratio or Fixed Charged Coverage)
Time interest earned indicates whether the business has earned sufficient profits to pay its periodical interest liabilities or not
EBIT / Interest Expense
Increasing Ratio is favorable for the bank because it may attract the investors.
Decreasing Ratio is not favorable for the bank because company has been less able to cover the interest on the debt
Your banker will be looking for your TIE ratio to be 2.0 or greater, showing that your business is earning the interest charges two or more times each year
· Debt Ratio
Debt ratio used to measure a company's financial risk by determining how much of the company's assets have been financed by debt
Total Liabilities / Total assets
A debt ratio of greater than 1 indicates that a company has more debt than assets
A debt ratio of less than 1 indicates that a company has more assets than debt
Increasing Debt Ratio is favorable for the banks (But not more than 1) and not favorable for the companies.
Decreasing Debt Ratio is not favorable for the banks and favorable for the companies.
· Debt / Equity Ratio
Debt/equity ratio is a measure of financial leverage of a company calculated by dividing its total liabilities by stockholders' equity.
Total Liabilities / Total Shareholder Equity
Ideally, the banks want to see a ratio of 2:1, which equates to a 2.0 or less. As your ratios edge above this level the loan becomes a riskier proposition for the bank, and there is a good chance that your credit application will be declined.
· Debt to Tangible Net worth Ratio
This ratio measures the physical worth of a company excluding any value derived from intangible assets such as patents copyrights, and intellectual property. It is calculated by taking total assets and subtracting the value of all liabilities and intangible assets of a company.
Total Debt / Tangible net worth
· Total Capitalization Ratio
The capitalization ratio measures the debt component of a company's capital structure, or capitalization (i.e., the sum of long-term debt liabilities and shareholders' equity) to support a company's operations and growth.
Longterm debt / Longterm debt + Shareholder equity
There is no standard or benchmark for setting the right or optimum amount of debt. Leverage will depend on the type of industry, line of business and the stage of development of the company (and its products). However, it is commonly understood that low debt and high equity levels in the capitalization ratio indicates good quality of investment.
Profitability Ratios:-
Profitability ratios measure the earning ability of a firm
All Below Ratios if increasing is good decreasing not good.
ü Net Profit Margin
This ratio shows profitability of the bank against it sales.
Profit after Tax / Net Sales x 100
ü Return on Assets
ROA is measure of a company's profitability, equal to EBIT divided by its total assets, expressed as a percentage.
EBIT / Total Assets x 100
ü DuPont Return on Assets
Dupont ROA is an approach that determines the impact of asset turnover and profit margin on profits.
Net Income / Sales x Sales / Total Assets x 100
ü Operating Income Margin
Operating income margin is used to measure a company's pricing strategy and operating efficiency.
EBIT / Net Sales x 100
ü Return on Operating Assets
The return on operating assets measure only includes in the denominator those assets actively used to create revenue.
EBIT / Operating Assets x 100
ü Return on Total Equity
Return on equity measures a corporation's profitability by revealing how much profit a company generates with the money shareholders have invested.
Net income / Shareholder Equity x 100
ü Gross Profit Margin
Gross Profit Margin measures the Gross Profit in relation to the Net Sales.
Gross Profit / Net Sales x 100
Activity Ratios:- (Efficiency Ratios)
Activity ratios measure a firm's ability to convert different accounts within their balance sheets into cash or sales.
These include
ü Total Assets Turnover
Asset turnover measures how effectively a business is using assets to generate sales.
Net Sales / Total assets
Increasing Ratio is good for Bank and companies
Decreasing Ratio is bad for bank and companies
ü Fixed Assets Turnover
Fixed Assets Turnover ratio indicates how well the business is using its fixed assets to generate sales.
Net Sales / Fixed Assets
Increasing Ratio is good for Bank and companies
Decreasing Ratio is bad for bank and companies
Market Ratios:-
Market ratios measure investor response to owning a company's stock and also the cost of issuing stock.
These Include:
ü Dividend Per Share
Dividend per share is used to measure the income received by shareholders from each share owned.
Total Dividend / Numbers of share outstanding
Increasing Ratio for banks is good because it will attract more investors.
Decreasing ratio for banks is not good because the investors will not invest.
ü Earning Per Share
Earnings per share serve as an indicator of a company's profitability.
Net Income / Numbers of Share Outstanding
Increasing Ratio for banks is good because it will attract more investors.
Decreasing ratio for banks is not good because the investors will not invest.
ü Price/Earning Ratio
Price/Earning ratio is a valuation ratio of a company's current share price compared to its per-share earnings.
Market Value per Share / Earning per share
Increasing Ratio for banks is good because it will attract more investors.
Decreasing ratio for banks is not good because the investors will not invest.
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█▓▒░ Hafiz Salman Majeed░▒▓█
