# Financial Analysis

Financial analysis is a tool to find out the financial position of an organization. It is a process of analyzing the various items of financial statements to measure the various strength and weakness aspect of organization. In other words, financial analysis involves analyzing financial statements prepared in accordance with generally accepted accounting principles to ascertain information concerning the magnitude, timing, and riskiness of future cash flows. Financial analysis means generally ratio analysis. Financial ratio analysis determines and interprets the numerical relationship between figures of financial statements. Ratio is used for evaluating the financial position and performance of a firm. It helps to make quantitative judgment about the financial position and performance of firm and provide information relating to strength and weakness of the firm.

Types of financial ratios

Liquidity ratios:
Liquidity ratios measure the short term solvency or liquidity of a firm. Liquidity is the ability of a firm to meet its short term obligation. These ratio measures the firm’s ability to satisfy its short term commitments out of current or liquid assets. Liquidity ratios reflect the short term financial strength of a firm and indicate whether a firm is in position to meet its short term obligation timely or not. These ratios focus on current assets and liabilities and are used to ascertain the short term solvency position of a firm. There are two ratios to measure the liquidity of a firm.

• Current ratio: A current ratio is the quantitative relationship between current assets and current liabilities. Its main objective is to measure the ability of the firm to meet short term obligation. Here, current assets are those assets which can convert into cash normally within a year. And those liabilities which are to be discharged normally within one accounting year are called current liabilities. This ratio is computed by dividing the current assets by the current liabilities. Normally a current ratio of 2:1 is considered as satisfactory.
• Quick ratio: This ratio is also known as liquid or acid test ratio. It shows the relationship between quick assets and current liabilities. Its main objective is to measure the ability of the firms to meet its short term obligations as and when without relying upon the realization of stock. This ratio is computed by dividing the quick assets by the current liabilities. It is usually expressed as a pure ratio like 1:1.
Assets management ratios
Assets management ratios are also known as turnover ratios or activity ratios or efficiency ratios. These ratio measures the effectiveness of firm’s assets utilization. These ratios are look at the amount of various types of assets and attempt to determine if they are too high or too low at the current operating levels. Follows are the ratios that are calculated to measure the efficiency of assets management.

• Inventory turnover ratio: It is also called stock turnover ratio. It shows the relationship between costs of goods sold and average inventory. The objective of this ratio is to determine the efficiency with which the inventory is converted into sales. This ratio is computed dividing costs of goods sold or net sales by average inventory closing inventory.
• Receivable turnover ratio: This ratio measures how many times the account receivable or debtor’s turnover occurs during the year. That means it indicates the number of times the firm collects its accounts receivable during the year. It is a general measure of the productivity of receivable investment and the test of the liquidity of debtors of a firm. A low receivable turnover ratio indicates that the firm is making excessive investment in receivable or it is unable to make timely collection of credit sales.
• Days sales outstanding: it is also known as average collection period. It is the average length of time that a firm takes to realize in cash after credit sales has been made and it measures how quickly the account receivable are being converted into cash. It shows the efficiency in collection process of the receivable. A lower average collection period signifies that the debtors are being collected rapidly and vice versa.
• Fixed assets turnover ratio: Fixed assets turnover ratio indicates the firm’s ability to generate sales based on various fixed assets. It measures the effectiveness of firm’s ability to make efficient utilization of fixed assets. It is calculated by dividing sales by the fixed assets net of depreciation. A low fixed assets turnover ratio indicates that the firm is using its fixed assets not as efficiently as other firm in the industry.
• Total assets turnover ratio: Total assets turnover ratio is the measure of the firm’s ability to make effective utilization of its total investment in assets in terms of generating sales revenue. It measures the efficiency of assets management in relation to all of the assets items. It is calculated as sales divided by total assets. A low assets turnover ratio indicates that the firm is unable to generate sufficient business volume in terms of generating sales revenue.

Debt management ratio

The debt management ratios are also known as leverage ratios or capital structure ratios and indicates the extent to which debt financing is being used by a firm. It is measure of long term solvency of firm and shows a firm’s ability to pay the interest regularly and repay the   principle on the due date. Long term solvency of a firm can be measured through the following ratios:

• Debt assets ratio: The debt assets ratio is simply known as debt ratio and shows the proportion of total debts used in financing total assets of firm. It indicates the percentage of total assets which is financed with debt capital and computed by dividing the total debt by total assets.
• Debt equity ratio:  Debt equity ratio is also called debt to shareholder’s fund ratio and most widely used leverage ratio to evaluate the long term solvency of a firm. This ratio expresses the relationship between debt capital and equity capital, and reflects the relative claim of them on the assets of the firm. It is computed by dividing the total debt by shareholders fund. A high debt equity ratio indicates that financing from creditor is higher than the owner and is risky.
• Equity multiplier: Equity multiplier simply states the relationship of total assets to equity of a firm. It measures the extent to which the total asset of a firm is greater than the firm’s equity capital. It is computed by dividing total assets by total equity.
• Interest coverage ratio: It is also known as time interest earned (TIE). It is the ratio that indicates the extent to which the firm is able to satisfy interest payments out of earnings before interest and taxes. It ascertains the ability of firm to pay interest on its borrowed capital and computed by dividing the EBIT by interest. A high interest coverage ratio shows that the firm is able to pay interest on borrowed capital and vice verse.
• Long term ratio: It is also called long term debt to total assets ratio. And this ratio represents the relationship between long term debts to total assets of firm. It is computed by dividing the long term debt by total assets.

Profitability ratio

Profitability is the end result of a number of corporate policies and decisions. It measures how efficiently the firm is being operated and managed. The long term survival of a company depends on income earned by it. So beside owners and managers, creditors are also interested to know the financial soundness of the firm. Therefore profitability ratios are calculated by firm because expectations of both owners and managers are evaluated in terms of profit earned by the firm. Following are the major ratios used to measure the profitability of a firm.
• Gross profit margin ratio: Gross profit margin ratio measures the relationship between gross profit and net sales. It is computed to determine the efficiency which production and or purchase operation and selling operation carried on. It is computed by dividing the gross profit by the net sales. It is expressed as percentage. A high gross profit margin signifies a good management good to low cost of production.
• Net profit margin ratio:  Net profit margin is the ratio between net income and sales of a firm. It shows the firm’s ability to generate net income per rupee of sales. The main objective of computing this ratio is to determine the overall profitability of a firm. It is computed by dividing the net profit after tax by net sales. A lower ratio is indication of poor financial planning and low efficiency and vice verse.
• Operating ratio: This ratio establishes the relationship between the operating expenses and sales value. It is very important in election to the cost structure of a firm. It is computed by dividing operating expenses by net sales. The higher operating ratio implies lower operating profit and vice verse.
• Basic earning power ratio: This ratio establishes the relationship between firm’s earnings before interest and tax and total assets. This ratio is calculated to evaluate the firm’s ability to generate profit before the payment of interest and taxes out of the assets used. It is computed by dividing the EBIT by total assets.
• Return on Assets (ROA): The return on assets which is often called return on total assets or return on investment measures the overall effectiveness of management in generating profit with its available assets. This ratio establishes the relationship between net profit and total assets or investment. It is computed by dividing the net profit after tax by total assets. Higher return on assets ratio implies the efficiency of the management in the utilization of total assets and vice verse.
• Return on Equity (ROE): The return on equity measures the return on the owner’s investment in the firm. Higher ratio of return on equity is better for owner. It is calculated by dividing the net income of the firm by total equity.