LIQUIDITY RATIOS, FINANCIAL LEVERAGE RATIOS AND PROFITABILITY RATIOS

Financial statements are the primary means through which accountants communicate information to the users of financial information.

The purpose of the financial statement is to convey basic information about a company to various stakeholders.

However, these statements provide financial information which requires analysis for making economic decisions by the external and internal users of the organisation.

It is for this reason that we used the financial ratio.

Financial ratios are indices that compare two accounting numbers and are often calculated by dividing two accounting numbers.

Financial ratios are useful tools for interpreting financial statements. They serve as useful indicators of a firm's financial performance and financial position.

Financial ratios can be categorized based on the data they provide. The following are most common classifications of financial ratios:

1. Liquidity ratios

2. Financial leverage ratios

3. Asset management ratios

4. Profitability ratios

Liquidity Ratios

A firm needs to be able to meet its obligations as they become due.

Liquidity ratios measure the ability of a company to meet its current obligations

They are financial metrics used to determine a company's ability to pay its current debt without external finance.

They are financial ratios that show the relationship between a firm"s cash and other current assets to its current liabilities.

Liquidity ratios are mainly used to measure the short-term solvency of the business i.e the business's ability to pay its maturing debt obligations and to satisfy unexpected needs for cash.

It is important to note that liquidity ratios are also called short term solvency ratios

Two commonly used liquidity ratios are the current ratio and the quick ratio.

Current ratio

This is a liquidity ratio that assesses a company's capacity to meet its short-term debt obligations without relying on external financing.

It indicates a company's ability to satisfy its current liabilities with its current assets

It is calculated by dividing current assets by current liabilities. That is to say,

$$\text{current ratio}=\frac{\text{current assets}}{\text{current liabilities}}$$

Perhaps, the best way to understand this is to practice with an example.

Example 1

A firm has current assets of N800,000. and current liabilities of N300,000. Calculate its current ratio

Solution:

Remember, $$\text{current ratio}=\frac{\text{current assets}}{\text{current liabilities}}$$

Hence, the current ratio=$\frac{800,000}{300,000}=2.67$.

The current ratio is the most commonly used measure of short-term solvency.

It provides the best single indicator of the extent to which the claims of short-term creditors are covered by assets that are expected to be converted to cash fairly quickly.

The ideal current ratio is 2, which indicate that a company can pay its current liabilities twice.

Quick ratio

Inventories are the least liquid current asset of a business, hence, they are the assets that are most likely to suffer losses in the case of a liquidation.

Therefore, a measure of the firm's ability to pay off short-term obligations without having to sell inventory sales is required.

The quick ratio is the liquidity ratio that measures a company's ability to pay its short term debt obligation without having to sell inventories or seek external financing.

It indicates the ability of a company to pay its current liabilities without taking inventory into consideration

That is, it measures a company's ability to pay bills any due over the next 12 months with its most liquid assets

The acid test ratio is another name for the quick ratio. The quick ratio is calculated by subtracting inventories from current assets and dividing the remainder by current liabilities.

That is,

$$\text{Quick ratio}=\frac{\text{current assets-inventories}}{\text{current liabilities}}$$

Example

A company has N800,000 in current assets and N300,000 in current liabilities. Given that its inventories amount to N370,000, Calculate its quick ratio

Solution

Quick ratio=$\frac{800,000-370,000}{300,000}=1.43$

The ideal quick ratio is 1, which indicate that a company has enough liquid asset to pay off its current asset.

In general, the higher these liquidity ratios, the better the company's ability to meet its immediate obligations.

If the liquidity ratios are low, it means that the company has a liquidity problem and may not be able to pay its short-term debts on time.

Financial Leverage Ratios

These analyze a company's entire debt picture to determine the worth of its equity.

They are also known as long term solvency ratios.

The debt-to-equity ratio, the debt-to-total assets ratio,  and the equity-to-total asset ratio are the four most commonly used financial leverage ratios.

Debt-to-equity ratio

It shows the relationship between external equities (debt) and internal equities (shareholder's equities).

In other words,  it shows the relationship between borrowed funds and the owner's capital.

The debt to equity ratio relates the debt of a company to its equities. It indicates the relative proportion of debts and equities in financing the assets of a business.

It also shows the mixture of internal and external equity in funding the assets of the business.

For this reason, the debt-to-equity ratio is sometimes called the external-internal equity ratio.

The debt-to-equity ratio also tells us the capital structure of a business. In other words, It shows the specific mix of equities and liabilities used to finance a company's assets

To calculate the debt-to-equity ratio, the formula is:

$$\text{Debt-to-equity ratio}=\frac{\text{Total liabilities}}{\text{Total equities}}$$

Generally, a high debt-to-equity ratio is a symptom of high financial risk or bankruptcy, as more debts are utilized to finance the business' assets than shareholder equity.

Therefore, every business should seek to keep its debt-to-equity ratio as low as possible.

Debt-to-total asset ratio

This shows the proportion of company assets that are financed through debts. It shows the percentage of the firm's assets that is supported by debt financing.

The debt-to-total asset ratio can be computed using this formula.

$$\text{debt-to-total asset ratio}=\frac{\text{Total liabilities}}{\text{Total assets}}$$

When the debt-to-total-asset ratio is less than one, it means that the company has more assets than a liability and can easily sell meet its obligations by selling its asset

If the debt-to-total asset ratio is exactly one, it indicates that all of the company assets are financed by liabilities or external equities

A debt-to-total-asset ratio greater than one implies that the company has more liabilities than assets, putting it at risk of being declared insolvent if creditors begin demanding payment.

It is vital to stress here that the debt-to-total-asset ratio is also known as the debt ratio.

Equity to total asset ratio

This shows the proportion of company assets that are financed through shareholder equity.

It measures a firm's total shareholder equity as a percentage of its total asset.

To calculate equity to total asset ratio, we use this formula:

$$\text{equity-to-total asset ratio}=\frac{\text{Total equities}}{\text{Total assets}}$$

A low equity-to-total asset ratio (say 0.1-0.4) may indicate financial risk as most of the company assets are financed by liabilities

If the equity-to-total asset ratio is exactly one, it means that all of the company assets are financed by shareholders' equities.

Just to be clear, the equity-to-total asset ratio is what is known simply equity ratio.

Profitability Ratios

These are used to show the combined effects of company liquidity, asset management and debt on its operating results (profit).

These ratios evaluate how well a company can generate profits from its operations.

Four profitability ratios can be identified: Net profit margin, gross profit margin, return on assets (investments) and return on equity.

The gross profit margin

This is a financial ratio that shows the gross profit per naira of sales.

It indicates the efficiency with which management produced each unit of product.

It is computed as gross profit divided by sales. That is,

$$GPM=\frac{\text{gross profit}}{sales}$$

Because gross profit is the difference between sales and the cost of goods sold, the gross profit margin can be derived by dividing the difference between sales and the cost of goods sold.

That is,

$$GPM=\frac{\text{Sales}-\text{Cost of goods sold}}{Sales}$$

A high gross profit margin means that the company has efficient at managing its cost of sales and has more to cover for normal operating expenses

The Net profit margin

This is a financial ratio that shows the net income or profit per naira of sales.

It shows the relationship between net profit (after-tax) and sales. It is calculated by dividing net income by sales.

It is expressed mathematically as follows:

$$\text{net profit margin}=\frac{\text{Net profit after taxes}}{\text{sales}}$$

Example

Calculate the profit margin of a firm which have a net income of N200 and sales of N4000.

Solution

Profit margin=$\frac{200}{4000}=5\%$

A high and positive net profit margin usually means that the company has leftover money for equity investors after all the company's expenses have been covered.

Return on asset

This is the ratio of net income to total assets. It measures the return on total assets (ROA) after interest and taxes.

In other words, It indicates the profitability on the asset of a company after all expenses and taxes have been deducted.

$$\text{Return on asset}=\frac{\text{Net income}}{assets}$$

Example

Calculate the return on assets of a firm that has a net income of N200 and total assets of N1600.

Solution

Return on asset=$\frac{N200}{N1600}=12.5\%$

The return on assets indicates the amount of net profit earned by utilizing each naira of total assets.

Hence, a high percentage of return of assets indicates that a company is efficient at generating income from its assets.

A low percentage of return on assets may indicate that a company is inefficient at generating income from its assets

Return on equity

This measures the amount of net income earned by utilizing each naira of total common equity. It measures the rate of return on common stockholders' investment.

It is the ratio of net income to common equity.

The formula for return on equity is

$$\text{Return on equity}=\frac{\text{Net income}}{\text{total common equities }}$$

Example

Given that the net income is N200,000 and common equity is N1,000,000. Calculate the return on equity

Solution

Return on equity=$\frac{200,000}{1,000,000}=20\%$

A high percentage of return on equity indicates that the company management is efficient at generating income on its shareholder's equity financing

A low percentage of return on equity may indicate the company management is inefficient at generating income on its shareholder's equity financing.

Asset Management Ratios

Asset management ratios are a collection of financial ratios that measures the efficiency of a firm in managing its assets.

They tell us how well the firm assets are being used and managed.

They relate the balance sheet(assets) to the income statement (sales).

They show the relationship between sales and assets.

Asset management ratios are also called efficiency ratios, activity ratios, turnover ratios

Five asset management ratios will be discussed, namely: inventory turnover ratio, receivable turnover, the average collection period, fixed assets turnover ratio and the total asset turnover, debtor turnover ratio.

Inventory turnover ratio

This is a financial ratio that shows the number of times a company has sold, used or replenish its inventories in a given period.

It is the financial ratio that tells you the number of times a company inventory Is being converted to revenue (through sales).

The inventory turnover ratio indicates the efficiency of the firm in selling its product.

It indicates the effectiveness of a company's inventory management practices.

It can be used to determine whether a company is managing its stocks properly or not

It is easily computed by dividing sales by inventories.

$$\text{inventory turnover ratio}=\frac{\text{sales}}{\text{inventories}}$$

Example

Calculate the inventory turnover ratio of victor LTD, if its sales are N4,000,000 and its receivables amount to N350,000

Solution

$\text{inventory turnover ratio}=\frac{\text{sales}}{\text{inventories}}$

Accordingly,

Inventory turnover ratio=$\frac{N4,000,000}{N370,000}$=10.8 times.

This indicates that Victor LTD's inventory is sold out and "turn over" 10.8 times a year.

The average collection period

This indicates the average length of time the firm must wait after making a sale before it receives cash.

It indicates the average number of days that receivables are outstanding

It is used to appraise account receivables and determine the effectiveness of a firm's credit policies.

It is calculated as accounts receivable divided by average sales per day.

$$ACP=\frac{\text{receivables}}{\text{Average credit sales per day}}$$

Where average sales per day is total sales divided by 360.

Also, the  average collection period can be calculated as:

$$ACP=\frac{360}{\text{debtors turnover}}$$

Furthermore, it can also be calculated as:

$$ACP=\frac{\text{Average debtors}}{\text{credit sales}}\times 360$$

Example

Calculate the average collection period of Victor LTD, given that account receivable, is N350,000 and total sales amount to N4,000,000.

Solution

$$ACP=\frac{\text{receivable}}{\text{Average sales per day}}$$

First, we need to determine the sales per day.

The sales per day=4,000,000÷360=N11,111

Hence, the average collection period is

$ACP=\frac{350,000}{11,111}=32$ days

It is important to note that the average collection period is also called Days sales outstanding (DSO)

Fixed asset turnover ratio

This measures how effectively the firm uses its fixed assets.

It is the ratio of sales to average fixed assets

it is calculated as total sales divided by average fixed assets

$$\text{fixed asset turnover ratio}=\frac{sales}{\text{average fixed assets}}$$

Example

Given that sales are N4,000,000 and average fixed assets are N800,000. Determine the fixed asset turnover ratio.

Solution

$\text{fixed asset turnover ratio}=\frac{4,000,000}{800,000}=5$

Total assets turnover ratio

This measures the turnover of all the firm's assets.

It indicates the value of a company's revenue relative to the value of its assets.

Asset turnover ratio can be used to show the  effectiveness of the firm in utilizing its assets to generate sales

It is calculated by dividing sales by total average total assets.

$$\text{Total asset turnover ratio}=\frac{sales}{\text {Average Total assets}}$$

Example

Given that sales are N4,000,000 and average total assets are N1,600,000. Determine total asset turnover ratio.

Solution

total asset turnover ratio=$\frac{4,000,000}{1,600,000}=5$.

Debtors turnover ratio

This ratio represents the number of times debtors turnover each year.

It is computed as:

$$DTR=\frac{\text{credit sales}}{\text{average debtors}}$$

In general, the larger the value of the debtors turnover, the more efficient is the firm's management of credit

Final words

It should be noted that financial ratios are prepared from information on the financial statements.

So, if there are errors in the financial statement, the financial ratios derived from such statements will automatically be erroneous.

For a recap, the following financial ratios are discussed in this post.

$$\text{current ratio}=\frac{\text{current assets}}{\text{current liabilities}}$$

$$\text{Quick ratio}=\frac{\text{current assets-inventories}}{\text{current liabilities}}$$

$$\text{Debt-to-equity ratio}=\frac{\text{Total liabilities}}{\text{Total equities}}$$

$$\text{debt-to-total asset ratio}=\frac{\text{Total liabilities}}{\text{Total assets}}$$

$$\text{equity-to-total asset ratio}=\frac{\text{Total equities}}{\text{Total assets}}$$

$$\text{profit margin}=\frac{\text{Net profit after taxes}}{\text{sales}}$$

$$\text{Return on asset}=\frac{\text{Net income after sales}}{assets}$$

$$\text{Return on equity}=\frac{\text{Net income}}{\text{total common equities }}$$

$$\text{inventory turnover ratio}=\frac{\text{sales}}{\text{inventories}}$$

$$ACP=\frac{\text{receivable}}{\text{Average credit sales per day}}$$

$$\text{fixed asset turnover ratio}=\frac{sales}{\text{average fixed assets}}$$

$$DTR=\frac{\text{credit sales}}{\text{average debtors}}$$

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