Ratios and Formulas in Customer Financial AnalysisEssay Preview: Ratios and Formulas in Customer Financial AnalysisReport this essayRatios and Formulas in Customer Financial AnalysisFinancial statement analysis is a judgmental process. One of the primary objectives is identification of major changes in trends, and relationships and the investigation of the reasons underlying those changes. The judgment process can be improved by experience and the use of analytical tools. Probably the most widely used financial analysis technique is ratio analysis, the analysis of relationships between two or more line items on the financial statement. Financial ratios are usually expressed in percentage or times. Generally, financial ratios are calculated for the purpose of evaluating aspects of a companys operations and fall into the following categories:
liquidity ratios measure a firms ability to meet its current obligations.profitability ratios measure managements ability to control expenses and to earn a return on the resources committed to the business.leverage ratios measure the degree of protection of suppliers of long-term funds and can also aid in judging a firms ability to raise additional debt and its capacity to pay its liabilities on time.
efficiency, activity or turnover ratios provide information about managements ability to control expenses and to earn a return on the resources committed to the business.
A ratio can be computed from any pair of numbers. Given the large quantity of variables included in financial statements, a very long list of meaningful ratios can be derived. A standard list of ratios or standard computation of them does not exist. The following ratio presentation includes ratios that are most often used when evaluating the credit worthiness of a customer. Ratio analysis becomes a very personal or company driven procedure. Analysts are drawn to and use the ones they are comfortable with and understand.
Liquidity RatiosWorking CapitalWorking capital compares current assets to current liabilities, and serves as the liquid reserve available to satisfy contingencies and uncertainties. A high working capital balance is mandated if the entity is unable to borrow on short notice. The ratio indicates the short-term solvency of a business and in determining if a firm can pay its current liabilities when due.
* FormulaCurrent Assets– Current LiabilitiesAcid Test or Quick RatioA measurement of the liquidity position of the business. The quick ratio compares the cash plus cash equivalents and accounts receivable to the current liabilities. The primary difference between the current ratio and the quick ratio is the quick ratio does not include inventory and prepaid expenses in the calculation. Consequently, a businesss quick ratio will be lower than its current ratio. It is a stringent test of liquidity.
* FormulaCash + Marketable Securities + Accounts ReceivableCurrent LiabilitiesCurrent RatioProvides an indication of the liquidity of the business by comparing the amount of current assets to current liabilities. A businesss current assets generally consist of cash, marketable securities, accounts receivable, and inventories. Current liabilities include accounts payable, current maturities of long-term debt, accrued income taxes, and other accrued expenses that are due within one year. In general, businesses prefer to have at least one dollar of current assets for every dollar of current liabilities. However, the normal current ratio fluctuates from industry to industry. A current ratio significantly higher than the industry average could indicate the existence of redundant assets. Conversely, a current ratio significantly lower than the industry average could indicate a lack of liquidity.
* FormulaCurrent AssetsCurrent LiabilitiesCash RatioIndicates a conservative view of liquidity such as when a company has pledged its receivables and its inventory, or the analyst suspects severe liquidity problems with inventory and receivables.
* FormulaCash Equivalents + Marketable SecuritiesCurrent LiabilitiesProfitability RatiosNet Profit Margin (Return on Sales)A measure of net income dollars generated by each dollar of sales.* FormulaNet Income *Net Sales* Refinements to the net income figure can make it more accurate than this ratio computation. They could include removal of equity earnings from investments, “other income” and “other expense” items as well as minority share of earnings and nonrecuring items.
Return on AssetsMeasures the companys ability to utilize its assets to create profits.* FormulaNet Income *(Beginning + Ending Total Assets) / 2Operating Income MarginA measure of the operating income generated by each dollar of sales.* FormulaOperating IncomeNet SalesReturn on InvestmentMeasures the income earned on the invested capital.* FormulaNet Income *Long-term Liabilities + EquityReturn on EquityMeasures the income earned on the shareholders investment in the business.* FormulaNet Income *EquityDu Pont Return on AssetsA combination of financial ratios in a series to evaluate investment return. The benefit of the method is that it provides an understanding of how the company
s capital structure differs and the differences are not expected to change. FormulaNet Income is based on the earnings of shareholders in the company, not the operating company. It does not include the sale of the Company’s stake in a mutual fund based on a share trade or an exercise of a share ownership stake in a mutual fund. FormulaNet Income can also be used to determine the company’s stock price or the amount held by an employee or an individual. For example, if an employee is required to receive compensation, FormulaNet Income may be used to determine when all of that compensation may be earned, subject to certain limitations from the plan. (The amount is calculated based on the performance of the employee’s employees. It also determines the overall value and performance of the plan for the year.) A separate formula may be used to determine a company’s dividend. FormulaNet Income also may be used to determine the shareholder’s current stock appreciation. This formula was first made to provide information on “capital distributions” by the SEC in the second paragraph of a rule that was adopted by the SEC for the first year of the current rule. It has since been updated to include additional information. FormulaNet Income also can be used for determining a company’s long-term debt amount or the amount of the company’s accrued indebtedness. FormulaNet Income may be used to determine company’s equity or total cash or cash equivalents. FormulaNet income is based on a number of variables. See the section on “Additional Information” below for more information.