A NOTE ON FINANCIAL RATIO ANALYSIS

<<Previous

LEVERAGE/CAPITAL STRUCTURE RATIO

These ratios measure the long-term solvency of a firm. Financial leverage refers to the use of debt finance. While debt capital is a cheaper source of finance, it is also a risky source. Leverage ratios help us assess the risk arising from the use of debt capital. Two types of ratios are commonly used to analyze financial leverage - structural ratios and coverage ratios. Structural ratios are based on the proportions of debt and equity in the financial structure of a firm. Coverage ratios show the relationship between the debt commitments and the sources for meeting them.

The long-term creditors of a firm evaluate its financial strength on the basis of its ability to pay the interest on the loan regularly during the period of the loan and its ability to pay the principal on maturity.

RATIOS COMPUTED FROM BALANCE SHEET

Debt-Equity: This ratio shows the relative proportions of debt and equity in financing the assets of a firm. The debt includes short-term and long-term borrowings. The equity includes the networth (paid-up equity capital and reserves and surplus) and preference capital. It can be calculated as:

Debt / Equity

Debt-Asset Ratio: The debt-asset ratio measures the extent to which the borrowed funds support the firm's assets. It can be calculated as:

Debt / Assets

The numerator of the ratio includes all debt, short-term as well as long-term, and the denominator of the ratio includes all the assets (the balance sheet total).

AVERAGE COLLECTION PERIOD (ACP)

ACP is calculated by dividing the days in a year by the debtors' turnover. The average collection period represents the number of day's worth of credit sales that is blocked with the debtors (accounts receivable). It is computed as follows:

Average Collection Ratio = Months (days) in a Year / Debtors Turnover

The ACP and the accounts receivables turnover are related as:

ACP = 365 / Accounts Receivable Turnover

The ACP can be compared with the firm's credit terms to judge the efficiency of credit management. For example, if the credit terms are 2/10, net 45, an ACP of 85 days means that the collection is slow and an ACP of 40 days means that the collection is prompt.

INVENTORY OR STOCK TURNOVER RATIO (ITR)

ITR refers to the number of times the inventory is sold and replaced during the accounting period. It is calculated as follows:

Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory

ITR reflects the efficiency of inventory management. The higher the ratio, the more efficient is the management of inventories, and vice versa. However, a high inventory turnover may also result from a low level of inventory which may lead to frequent stock outs and loss of sales and customer goodwill. For calculating ITR, the average of inventories at the beginning and the end of the year is taken. In general, averages may be used when a flow figure (in this case, cost of goods sold) is related to a stock figure (inventories).

FIXED ASSETS TURNOVER (FAT)

The FAT ratio measures the net sales per rupee of investment in fixed assets. It can be computed as follows:

FAT = Net sales / Average net fixed assets

This ratio measures the efficiency with which fixed assets are employed. A high ratio indicates a high degree of efficiency in asset utilization while a low ratio reflects an inefficient use of assets. However, this ratio should be used with caution because when the fixed assets of a firm are old and substantially depreciated, the fixed assets turnover ratio tends to be high (because the denominator of the ratio is very low).