Project Ratios

Project Ratios

Liquidity Ratios

Liquidity ratios are used by the firm to determine its ability to meet short-term obligations, such as payment of Account Payables, Bank Overdraft and other accrued expenses. The management should make proper cash decisions to avoid cash flow problems. The current ratio and quick ratio can measure of liquidity.  The current ratio assists the firm in determining its ability to pay current liabilities with the use of current assets. The quick ratio measures the firm ability to meet short-term obligations by use quick assets. Quick assets comprise account receivable, cash equivalents and cash.

Current ratio = Currents assets / current liabilities

Quick ratio = (Accounts receivable + cash + cash equivalents) / current liabilities

Leverage Ratios

Leverage ratios indicate the level of debt a firm has compared to either assets or equity (Hashim, 2018). A high level of the ratio will indicate a firm is highly financed with debt and may result in financial risk. Financial risk is the likely hood a firm may fail to meet its financial obligation and lead to the bankruptcy of the company. A lower level of leverage is preferred since they will be no financial risk. The leverage ratio can be computed using debt to equity, debt to total assets and interest coverage. The debt to equity ratio determines the financing that comes from shareholders and creditors. The lower level of the ratio indicates higher financing comes from shareholders as compared to creditors. Debt to total assets ratio determines the proportion of total assets that are financed by liabilities. Interest coverage ratio measures the ability of a business to pay interest expense when they fall due.

Debt to Equity ratio = Total liabilities / Total equity

Debt to Asset Ratio = Total debts / Total Assets

Interest coverage ratio = (Earnings Before Interest and Taxes) / Interest Expense

Management Efficiency Ratios

Management efficiency ratios are used to determine the ability of a firm to manage liabilities by use of its assets in the short-term. Efficiency ratios comprise Account Receivable Turnover, Days Sales Outstanding,  Days of Inventory and Accounts Payable Turnover.  Accounts Receivable Turnover determines the efficiency of a firm to collect cash from debtors; a lower number of days will be preferred. The ratio is computed by taking average account receivables, multiplied by the number of working days and then divided by net sales. Sales are assumed to credit sales. Average Account Receivables are computed by getting an average of beginning and closing debtors. Days Sales Outstanding is the same as Accounts Receivables Turnover and it has been discussed. Days of Inventory or Inventory Turnover Period refer to the number of days required to convert inventories into cash; a lower number of days will be preferred. The ratio is calculated by multiplying average inventory with a number of working days, then divided by the cost of goods sold. Accounts Payable Turnover refers to the period that will pay for their purchases; a longer period will be preferred. If the firm delays paying its accounts payable, they can invest that cash to generate income. The ratio is computed by multiplying  Average Accounts payables times number of working days and the results credit purchases. Average Accounts Payable is computed by adding the beginning and ending creditors and dividing the results by two.

Accounts Receivable Turnover = (Average Accounts Receivable / Net Sales) * 365

Days of Inventory =  (average inventory * 365) /cost of goods sold

Average Accounts Payable = (Average Accounts Payable / Credit purchases) * 365

Profitability Ratios

Profitability ratios measure the ability of a firm to generate profits from its business activities. The ratio compares income statement profits with sales revenue or assets or equity. Generally, a high er profitability ratio will be preferred for all ratios under this category. Profitability ratio includes Gross Margin, Operating Margin, Return on Assets and Return on Equity. Gross profit is computed by taking gross margin over sales revenue; the answer is given as a percentage. The ratio determines the profitability of the firm after taking into account the cost of goods sold. Operation Margin is used to determine the profitability of the firm from its core business. The ratio is calculated by taking operating income ( net income before tax and interest) over the sales revenue and multiplied by a hundred. Return on Assets (ROA) measures how well a firm can manage its assets to generate profits. ROA is computed by taking net income as the numerator and dividing by average total assets. The average total assets is computed by getting an average of beginning and ending total assets. Return on Equity (ROE) measures the ability of the firm to generate profits from shareholders’ investment. ROE is computed by having net income as the numerator and then divided by equity (Drake & Fabozzi 2012).

Gross Margin = (Gross profit / Sales Revenue) * 100

Operating Margin = (Operating Income / Sales Revenue) * 100

Return on Asset = Net Income / Average Total Assets.

Return on Equity = Net Income /  Shareholder’s Equity

References

Drake, P. P., & Fabozzi, F. J. (2012). Financial Ratio Analysis. Encyclopedia of Financial Models. doi: 10.1002/9781118182635.efm0074

Hashim, S. L. M. (2018). Assessing The Performance Of Commercial Banks In Malaysia: Financial Ratio Analysis. doi: 10.15405/epsbs.2018.07.02.64