Literature review on ratio analysis

Current ratio.

The current ratio is also called the working capital ratio, as working capital is the difference between current assets and current liabilities. This ratio measures the ability of a company to pay its current obligations using current assets. The current ratio is calculated by dividing current assets by current liabilities. This ratio indicates the company has more current assets than current liabilities.

Different industries have different levels of expected liquidity.

Whether the ratio is considered adequate coverage depends on the type of business, the components of its current assets, and the ability of the company to generate cash from its receivables and by selling inventory. These assets are considered to be very liquid easy to obtain cash from the assets and therefore, available for immediate use to pay obligations.

The traditional rule of thumb for this ratio has been Anything below this level requires further analysis of receivables to understand how often the company turns them into cash. It may also indicate the company needs to establish a line of credit with a financial institution to ensure the company has access to cash when it needs to pay its obligations. Receivables turnover. The receivable turnover ratio calculates the number of times in an operating cycle normally one year the company collects its receivable balance.

It is calculated by dividing net credit sales by the average net receivables.


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Net credit sales is net sales less cash sales. If cash sales are unknown, use net sales. Average net receivables is usually the balance of net receivables at the beginning of the year plus the balance of net receivables at the end of the year divided by two. If the company is cyclical, an average calculated on a reasonable basis for the company's operations should be used such as monthly or quarterly.

Average collection period. The average collection period also known as day's sales outstanding is a variation of receivables turnover. It calculates the number of days it will take to collect the average receivables balance. It is often used to evaluate the effectiveness of a company's credit and collection policies.

A rule of thumb is the average collection period should not be significantly greater than a company's credit term period. The average collection period is calculated by dividing by the receivables turnover ratio. The decrease in the average collection period is favorable. If the credit period is 60 days, the 20X1 average is very good.

However, if the credit period is 30 days, the company needs to review its collection efforts.

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Inventory turnover. The inventory turnover ratio measures the number of times the company sells its inventory during the period. It is calculated by dividing the cost of goods sold by average inventory. Average inventory is calculated by adding beginning inventory and ending inventory and dividing by 2.

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Day's sales on hand. Day's sales on hand is a variation of the inventory turnover. It calculates the number of day's sales being carried in inventory. It is calculated by dividing days by the inventory turnover ratio. Profitability ratios measure a company's operating efficiency, including its ability to generate income and therefore, cash flow.

Cash flow affects the company's ability to obtain debt and equity financing. Profit margin. The profit margin ratio , also known as the operating performance ratio, measures the company's ability to turn its sales into net income. To evaluate the profit margin, it must be compared to competitors and industry statistics. It is calculated by dividing net income by net sales. Asset turnover.

Profitability Ratio Analysis Finance Essay

The asset turnover ratio measures how efficiently a company is using its assets. Gombola and Ketz found that the fund and income statement are produced for different purpose and profitability ratios did not has the information that cash flow ratios provide. In other words both ratios gave important as well as different information from one and other. In s many nations expressed interest in ratio analysis.

History of Financial Ratios

Current ratio has used in credit management in Australia after intense scrutiny. In other wards British method is more management oriented than American system that is credit oriented. Indian and Canadian system is similar to American system and same kind of ratios and criteria has been used. In Japan data is available in grouping on the basis of industry and sizes of firms. China and Russia used several ratios as control measure in investment and working capital. Pinches and Mingo evaluate the structure of ratios and found that ratios can be divided into different groups.

Empirical analysis of financial ratios:

Present general classification of financial ratios on logical basis. Results concluded that the ratios can be divided into four groups that are financial leverage, short-term capital intensiveness, return on investment and long-term capital intensiveness. Stevens also studies the topic of ratio classification and grouped the financial ratios in four categories that include activity, liquidity, leverage and profitability.

Pinches, Mingo, and Caruthers and Pinches, Eubank, Mingo, and Caruthers carry on further worked on this subject and categorized the financial ratios in seven factors that include receivable turnover, capital turnover, short-term liquidity, return on investment, inventory turnover, financial leverage and cash position. Libby also studies the division of financial ratios and condenses that division from seven to five. Five divisions include liquidity, activity, cash position, profitability and assets balance. Johnson further studies the research of Pinches and added another factor that is decomposition measure into seven factors.

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Twelve different factors or division of financial ratios are presented in five different studies. On the basis of five published studies assortment of financial ratios are very time consuming because the results of published studies was very diverse. Chen and Shimerda deeply examined five published studies and find out that some of the twelve factors that has been presented in the studies has same and simply name is changed. Therefore, twelve factors are grouped into seven factors.


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Seven factors are cash position, financial leverage, inventory turnover, short-term liquidity, return on investment, receivable turnover and capital turnover. Financial ratio analyses play a vital role in analyzing the financial situation of the company. Four companies and 35 financial ratios has been used for this study. Five groups are formed from 35 financial ratios that include market ratios, liquidity ratios, debt ratios, profitability ratios and efficiency ratios.

Results of this study proved that the financial performance of Fauji fertilizer company ltd is best among other companies that has been included in the research from to Financial performance of a firm can be calculated with the help of financial ratios. By using ratios companies can determine financial strength or weaknesses as well as opportunities in the market or industry. Data from different financial statements has used to calculate the ratios. Financial ratios can tell the investors future performance of firms by looking past trends.

Ratios helped management to act more logically and made financial decision on more knowledge and less risky. Fauji fertilizer company ltd gave strong financial performance within chemical sector during to To evaluate the performance in intra industry ratios of Fauji fertilizer company ltd is compared with companies of automobile sector for the period of to The objective of the study was finding the trend in financial performance of both the industries.

To examined the financial performance five groups are formed from 35 financial ratios that include:. Results from this study proved that the financial trend, performance and ratios of the companies that has been used in the study was unequaled. In other words financial results of both industries are diverse and differed and no company within automobile sector gave strong financial performance that matched the performance of Fauji Fertilizer Company limited. Financial ratios helped to separate profitable firms from non profitable firms that were confirmed from past studies.

This study also concluded that profitable firms has higher financial ratios than non profitable firms. Financial ratios has been used since early ages but still lack clear theoretical structure for selecting suitable ratios for analysis. Lot of work has been done in this field but still huge possibilities of improvement are available. Financial ratio analysis is a good choice for uncomplicated and immediate analysis of financial position of the company with considerable prediction power.

With the help of financial ratio analysis future performance of the company can be predicted by studying the past trend of performance. This allows the investors and shareholders to invest on the basis of actual fact and figures rather than on different assumptions. To reduce the fluctuation in the ratios and made the results more reliable no. Ratios analysis assists the companies to gain insight knowledge as well as external opportunities to forecast future investment trends.

This analysis facilitates the companies to focus on weak points and improved them as well as takes benefits from strong points. Ratios also help the investors and shareholders to forecast return. Reducing errors and inefficiency of ratio analysis greatly help to increase the accuracy and usefulness in future studies. If you are the original writer of this essay and no longer wish to have the essay published on the UK Essays website then please:.

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