Introducing ratio analysis part 1; liquidity and leverage
This is the first post in a three part series which will introduce one of the core methods of fundamental analysis; ratio analysis.
Ratio analysis is one of the most powerful tools available to help interpret financial statements and better understand the strength or weakness of the underlying business. Financial ratios can let the investor know about the financial condition of the organization, the efficiency of its operations, the profitability of the company, the ranking of the company among its peers and the perception of the company in financial markets.
Although ratio analysis is quite a powerful tool, relying solely on financial ratios to arrive at investing decisions can be dangerous. This series of posts will explain how to calculate the key ratios from the financial statements of the company and explain what these ratios can tell you about the business in question.
This post will introduce you to Liquidity ratios and Leverage Ratios. The second post will cover Activity Ratios. The third in the series will look at Profitability and Valuation Ratios. This three part series will be followed up with a post explaining some common mistakes that are to be avoided when using ratio analysis.
So here we go…
Liquidity Ratios
These ratios measure the capability of the firm to meet its immediate liabilities. In other words they check whether the firm has got enough working capital to run its day to day activities. If the firm does not have enough working capital, it may be forced to sell its more profitable assets at a below par value. Lack of liquidity may also cause the firm to lose out on attractive opportunities available in the market. Hence ensuring that the firms you are investing into have sufficient working capital is very important. The key ratios that capture the liquidity aspects of the company are
a) Current ratio
Current ratio = Current Assets/ Current Liabilities.
There is no ‘particular value’ for the current ratio above which the firm could be declared as liquid. A healthy Current ratio is determined by the relationship between the cash inflows and outflows from the firm. Hence, it would be wise to compare the current ratio of the firm with other players in the same sector. Indian software companies have an average current ratio of 2.7, where as FMCG sector which generates quick cash has a current ratio as low as .86. A current ratio which is much higher the sectoral average might be pointing towards inefficiencies present in the company, such as high inventory, high amount of accounts to be received etc.
b) Quick ratio
Quick ratio = (Current Assets- Inventory)/ Current Liabilities
This ratio could be used in situations where there is a need to confirm the absolute liquidity of the company. Inventory, which is a less liquid form of asset compared to cash and marketable securities, is removed from the Current assets in order to find out the Current assets that could be quickly converted to cash .This ratio is also referred to as the Acid test ratio.
Leverage Ratios
These ratios assess the long –term solvency of the firm. A firm that has got a high amount of debt compared to share holder equity is referred to as a highly leveraged firm. The equity holders of high leverage firms get higher profits during boom times. On the other hand, when profits and cash flows fall the firm might be (in worst case) forced to bankruptcy due to the interest cost on debts.
The widely used ratio to assess financial leverage is the debt ratio
a) Debt ratio
Debt ratio= Total Debt /Total Assets
This ratio reflects the proportion of the assets that are funded with debt. Another version of this ratio, referred to as the Debt-to – Equity ratio is also commonly used. This is computed as Total Debt/Total Equity. As with the liquidity ratios there is no one level of this ratio which could be thought of as better than any other level. Generally, as this ratio increases the returns to share holders are higher, but their risks are higher as well.
b) Interest coverage ratio
The common ratio that is used to measure the ability of the company to meet its interest payments is the Interest coverage ratio. .It is defined as
Interest coverage ratio= Operating Income before interest and taxes/ Interest expenses
This ratio computes the number of times interest payments are covered by the firms operations. This ratio is also a measure of the staying power of the company under adversity.
Loading...