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Classification Of Ratios Essay

1261 words - 6 pages

Classification of ratios
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Activity Ratios

Activity ratios investigate the ways in which various resources of the business are managed.:

1. Inventory (stock) turnover period measures the average length of time items are held in inventory (stock) before being sold.
Means : The average time in days stock is being kept for.
Whats Hot : The shorter time, the better.

Inventory turnover period = Inventories x 365
Cost of sales

2. Settlement period for trade receivables (debtors) measures how long on average customers take to pay the amounts they owe. Companies will usually try to minimise the amount tied up in trade.
Means : How quickly an average debtor ...view middle of the document...

Revenue per employee measures of the productivity of the workforce. We can hear discussions of national rates of productivity per employee and per hour worked.
Means : How efficient are the employees
Whats Hot : The higher the better, effective use of resources

Revenue per employee = Revenue
Number of employees

Liquidity Ratios

Liquidity ratios are concerned with the company’s ability to meet its short-term financial obligations.

1. The current ratio estimates how liquid is the business. A higher current ratio may be thought to be preferable to a lower one, but if a business has a very high ratio, it may mean that funds are tied up in cash rather than being used more productively. You may come across the idea that there is an “ideal” current ratio of around 2 times.
Means : There are sufficient current assets to cover current liabilities as they fall due
Whats Hot : 2:1 is quoted as good, but depends on type of business

Current ratio = Current Assets
Current Liabilities

2. The acid test ratio is similar, but it represents a stricter test of liquidity. For many businesses, inventories (stock) cannot be converted quickly into cash. It may therefore be better to exclude this asset from the measure of liquidity.
Means : Coverage of current liabilities by “liquid” assets
Whats Hot : 1:1 is quoted as good, but again depends on business type.

Acid test ratio = Current assets – stock
Current liabilities

Financing Ratios

1) The interest cover ratio measures the risk for a company not to pay the interest due to banks, government and shareholders
Means : Amount of profit available to cover interest payments
Whats Hot : the higher, the more funds available to meet interest payments

Interest cover = PBIT We can also use the PBITDA
Interest payable
2) The debt to equity ratios = the gearing or the leverage, measures the contribution of long-term debt to the long-term capital structure of the business. Determine as a percentage
Means : Contribution of long-term lenders to the long-term capital structure
Whats Hot : not too high (ie not beyond c30%)

Total debt/equity = Long-term liabilities = Long term debt +short term debt
Shareholders’ funds Shareholders’ funds

Profitability Ratios

Profitability ratios measure the wealth created by the business (expressed as percentages).

1. The gross profit margin measures the profitability of buying and selling goods or services before any other expenses are taken into account
Means : Difference between sales and cost of sales and therefore profitability in buying or producing and selling goods.
Whats Hot : Hot if rising or stable, not good if going down.

Gross profit margin = Gross profit
Revenue (Sales)

2. The operating profit margin represents the profitability of the trading operations of the business. It is the...

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