Assignment 2: Submission—Course Project

Applied ratio analysis

A ratio is an expression of one item concerning the other. It is used to compare the groups of related items in the business, to assess the performance of the company. They include: Liquidity, solvency, and profitability

Solvency is referring to the ability of a firm to meet its long-term financial obligations as they all due. A company which is solvent owns more than what it owes to the outsides.

Liquidity refers to the capacity that is portrayed by an entity to settle its short-term or current commitments; further it is the rate at which a company converts its resources into cash and its equivalents. A business organization with some liquidity element might be unable to fix its long-term commitment.

Profitability refers to a company’s ability to amass optimal returns relative to its sales, assets, and equity. The term profitability is mostly used to ascertain if the firm's resources are being used effectively and efficiently- shade a limelight on the performance of the business unit.

The terms above are used to refer to the financial health of a company.

Solvency ratios

According to INVESTOPEDIA (2017), the following are some of the solvency ratios;

Debt to equity = Total debt / Total equity

This ratio shows the extents to which a company relies to external finance sources to fund its operation. These could be a short-term or long-term debt. The document further asserts that a rising debt-to-equity ratio implies higher interest expenses, and beyond a certain point, it may affect a company's credit rating, making it more expensive to raise more debt.

Debt to assets = Total debt / Total assets

This leverage measurement tool quantifies the percentage of a company's assets financed through debts. A higher ratio is unfavorable and might result into financial risk.

Interest coverage ratio

Interest coverage ratio = Operating income (or EBIT) / Interest expense.

It is a measure which indicates the capacity of an organization to settle its interest expense on debt with operating income- thus earnings before interest and tax (EBIT).

The higher the ratio indicates that the establishment is able to meet its interest expenses.

Liquidity ratios

Acid test ratio/quick ratio

This shows how fast the business can convert its current assets excluding stock to settle its current liabilities. That is;

Quick ratio = current assets-closing stock current liabilities

It is given in ratio form.

It helps in showing whether the company can meet its short-term operations with the liquid assets.

Day’s sales Outstanding

Days sales outstanding (DSO) = (Accounts receivable / Total credit sales) x Number of days in sales

DSO means to the average number of days used by a firm to collect payment for its credit sales. A higher DSO implies that a company is taking a lot of time to get its receivables thus a lot of capital being held by the account receivables (INVESTOPEDIA, 2017). This ratio is computed semi-annually, quarterly or annually.

Current ratio/working capital ratio

This is the ratio of the current assets to current liabilities. It can also be expressed as a percentage. That is:

Current ratio = current assets current liabilities

= current assets: current liabilities

Or

Current ratio = current assets /current liabilities x 100

The higher the working capital ratio, the better a company liquidity position is.

Profitability ratios

Mark-up

This is the comparison of gross profit as a percentage of cost of goods sold. i.e.

Mark-up = Gross Profit/Cost of Goods Sold × 100

= G.P/COGS × 100

Margin

This is the expression of the gross profit as a percentage of net sales. That is:

Margin = Gross Profit/net sales × 100

= G.P/sales × 100

Mark up and margin helps in the following; setting the selling price, calculating profit or losses and determining the sales for a given period

Return on capital

This is the expression of net profit as a percentage of the capital invested. That is;

Return on capital = net profit /capital invested x 100

It can be given as a ratio or a percentage.

Return on capital shows the following;

The performance of the business about other similar concerns.

Comparison of the performance of the business over different periods.

Help the potential investors on the decision on where to invest.

References

Gryglewicz, S. (2011). A theory of corporate financial decisions with liquidity and solvency concerns. Journal of Financial Economics, 99(2), 365-384.

INVESTOPEDIA. Financial Analysis: Solvency vs. Liquidity Ratios (2017). Retrieved http://www.investopedia.com/articles/investing/100313/financial-analysis-solvency-vs-liquidity-ratios.asp#ixzz4x4jeeC8X