Liquidity ratio is the ratio that calculates the company's ability on turning their asset into cash or the ability to pay. This ratio will help organization to measure the business' financial strength. There are two type of liquidity ratio; there are current ratio and quick ratio, it is refer as decisive test ratio.
Current ratio is the measurement of current asset divided by current liability, and it can be refer as the measurement of company's financial strength.
Current ratio formula:
When the current ratio is high, it is mean the company has high ability to change their asset into cash when they need to clear their debts.
Quick ratio is "the measurement of the amount of liquid asset that's available to meet obligations" (Prabir DAS). Stocks excluded in this ratio because it is illiquid asset. This ratio is to measure the ability of the company on paying without any rely on stock.
Quick ratio formula:
Investment ratio
This ratio is the most important for the company to show investor the value of their company and the benefit the will bring to their shareholder. By investigating, the ratios, the stakeholder will able, to analyze the future worth of the investment reflected in the market value of shares. There are three kind of calculation on investment ratio and there are Earning Per Share (EPS), Price Earning Ratio (PER) and Dividend Yield.
According to invetopedia.com, Earning Per Share (EPS) is defining as "…the portion of a company's profit allocated to each outstanding share of common stock…" In another words, EPS has used to measure the owner return or the profit that they can earn on every dollars they invest. Besides that, EPS is the indicator of the company's profitability and a major component used in calculating the Price Earning Ratio.
Earning Per Share Formula:
Price Earning Ratio is the measurement of determine how much does investor or shareholder willing to pay on stock relative to the company earning. When the ratio is high, its mean the investor need to pay more for earning profit from the company.
Price Earning Ratio Formula:
According to invetopedia.com, Dividend Yield is "…the financial ratio show how much a company pays out in dividend each year relative to its share price…" The dividend yield in also can be refer to the return on investment for a stock.
Dividend Yield formula:
Gearing ratio
Gearing ratio refer to the level of the debt. Gearing is a measure of financial leverage, demonstrating the degree to which a firm's activities are funded by owner's funds versus creditor's funds. (Investopedia 2010)
Gearing ratio formula:
Gearing ratio =
Gearing ratio getting higher means more the business is exposed to the fluctuation of interest rate and company has to pay back the interest and loans from being able to re-invest their earning.
Profitability
Profitability ratios provide information about management's performance in using the resources of the firm. (Bangs, David H., Jr. 1992) Profitability measures look at the potential of the firm generates profit from sales or from its capital assets. For this, it has different measures of profit, which are gross profit and net profit. Gross profit is a firm's residual profit after selling a product or service and deducting the cost associated with its production and sale. (Investopedia 2010) Net profit is also called 'net income'. It is a firm is total earning.
The profitability consists of five calculations, which are:
Gross profit margin
Net profit margin
Return on capital employed
Return on asset
Return on equity
Gross profit margin
Gross profit margin is also referring as 'gross margin'. It is a financial metric used to assess a firm's financial health by revealing the proportion of money left over from revenues after accounting for the cost of goods sold. (Investopedia 2010) Gross profit margin serves as the source for paying additional expenses and future savings. (Investopedia 2010)
Gross profit margin formula:
Gross profit margin =
Net profit margin
Net profit margin shows how much net profit is derived from every dollar of total sales. (Russell Wyrick 2008) It indicates how well the business has managed its operating expenses. It also can indicate whether the business is generating enough sales volume to cover minimum fixed costs and still left an acceptable profit. (Russell Wyrick 2008)
Net profit margin formula:
Net profit margin =
Return On Capital Employed
Return on capital employed is a ratio that indicates the efficiency and profitability of a firm's capital investments. (Investopedia 2010) It should always be higher than the rate at which the firm borrows; otherwise, any increase in borrowing will reduce shareholders' earnings. (Investopedia 2010)
Return on Capital Employed formula:
ROCE =
Return On Asset
Return on asset is an indicator of how profitable a firm is relative to its total assets. (Investopedia 2010) It gives an idea on how efficient management is by using its assets to generate earnings. (Investopedia 2010) This is calculated by dividing a firm's annual earnings by its total assets, which is displayed as a percentage. (Investopedia 2010)
Return on Asset formula:
ROA =
Return On Equity
Return on equity is the amount of net income returned as a percentage of shareholders equity. (Investopedia 2010) Return on equity measures a firm's profitability by revealing how much profit a firm generates with the money shareholders have invested. (Investopedia 2010)
Return of Equity formula:
ROE =
For example of profitability calculation:
Items
Amount (RM)
Turnover
300
Gross profit
150
Expenses
120
Net profit
80
Non current assets
370
Current assets
220
Current liabilities
85
Capital employed
405
Calculate the five profitability calculations.
Solution:
Gross profit margin =
=
= 50%
Net profit margin =
=
= 26.67
ROCE =
=
= 19.75%
ROA =
=
=
= 13.56%
ROE =
=
= 19.75%
Efficiency ratio
Efficiency ratios are typically used to analyze how well a firm uses its assets and liabilities internally. (Investopedia 2010) It evaluates how well the firm manages its assets. (Russell Wyrick 2008) The efficiency ratio can calculate the:
Stock turnover
Average collection period
Average payment period
Inventory turnover
Inventory turnover also called 'stock turnover'. It shows how many times in one accounting period the firm sells its inventory and is valuable for spotting under-stocking, overstocking, obsolescence and the need for merchandising improvement. (Russell Wyrick 2008) Faster turnovers are generally viewed as a positive trend; they increase cash flow and reduce warehousing rental and other related costs. (Russell Wyrick 2008)
Stock turnover formula:
Stock turnover =
* Cost of goods sold = Turnover - Gross profit
*Average stock =
Average collection period
Average collection period is the approximate amount of time that it takes for a business to receive payments owed, in terms of receivables, from its customers and clients. (Investopedia 2010) It show that the more shorter the period for the firm to collect back the money the more better the cash flow of the company.
Average collection period formula:
Average collection period =
Average payment period
Average payment period is shows how long the firm takes to pay their creditors. From this, the creditors have a power to withdraw credit if that the firm regularly pay late.
Average payment period formula:
Average payment period =
For example of efficiency ratio:
Items
Amount (RM)
Turnover
300
Gross profit
150
Expenses
120
Net profit
80
Non current assets
370
Debtors (Accounts receivable)
75
Cash
55
Inventory
90
Creditors (Accounts payable)
65
Capital employed
405
Calculate the efficiency calculation.
Stock turnover =
=
=
= 1.6
2 times
Average collection period =
=
= 91 days
Average payment period =
=
= 79 days
