A NOTE ON FINANCIAL RATIO ANALYSIS
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OPERATIONAL/TURNOVER RATIOS
These ratios determine how quickly certain current assets can be converted into
cash. They are also called efficiency ratios or asset utilization ratios as
they measure the efficiency of a firm in managing assets. These ratios are
based on the relationship between the level of activity represented by sales or
cost of goods sold and levels of investment in various assets. The important
turnover ratios are debtors turnover ratio, average collection period,
inventory/stock turnover ratio, fixed assets turnover ratio, and total assets
turnover ratio. These are described below:
DEBTORS TURNOVER RATIO (DTO)
DTO is calculated by dividing the
net credit sales by average debtors outstanding during the year. It measures
the liquidity of a firm's debts. Net credit sales are the gross credit sales
minus returns, if any, from customers. Average debtors is the average of
debtors at the beginning and at the end of the year. This ratio shows how
rapidly debts are collected. The higher the DTO, the better it is for the
organization.
Debtors Turnover Ratio = Net Credit Sales / Average Debtors |
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AVERAGE COLLECTION PERIOD (ACP)
ACP is calculated by dividing the days
in a year by the debtors' turnover. The average collection period represents the
number of day's worth of credit sales that is blocked with the debtors (accounts
receivable). It is computed as follows:
Average Collection Ratio = Months (days) in a Year / Debtors Turnover
The ACP and the accounts receivables turnover are related as:
ACP = 365 / Accounts Receivable Turnover
The ACP can be compared with the firm's credit terms to judge the efficiency of
credit management. For example, if the credit terms are 2/10, net 45, an ACP of
85 days means that the collection is slow and an ACP of 40 days means that the
collection is prompt.
INVENTORY OR STOCK TURNOVER RATIO (ITR)
ITR refers to the number of times the inventory is sold and replaced during
the accounting period. It is calculated as follows:
Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory
ITR reflects the efficiency of inventory management. The higher the ratio, the
more efficient is the management of inventories, and vice versa. However, a high
inventory turnover may also result from a low level of inventory which may lead
to frequent stock outs and loss of sales and customer goodwill. For calculating ITR, the average of inventories at the beginning and the end of the year is
taken. In general, averages may be used when a flow figure (in this case, cost
of goods sold) is related to a stock figure (inventories).
FIXED ASSETS
TURNOVER (FAT)The FAT ratio measures the net sales per rupee of investment in fixed assets. It
can be computed as follows:
FAT = Net sales / Average net fixed assets
This ratio measures the efficiency with which fixed assets are employed. A high
ratio indicates a high degree of efficiency in asset utilization while a low
ratio reflects an inefficient use of assets. However, this ratio should be used
with caution because when the fixed assets of a firm are old and substantially
depreciated, the fixed assets turnover ratio tends to be high (because the
denominator of the ratio is very low).
TOTAL ASSETS TURNOVER (TAT)TAT is the ratio between the net sales and the average total assets. It can be
computed as follows:
TAT = Net sales / Average total assets
This ratio measures how efficiently an organization is utilizing its assets.
LEVERAGE/CAPITAL STRUCTURE RATIO
PROFITABILITY RATIOS
VALUATION RATIOS
CALCULATING FINANCIAL RATIOS OF HLL
COMMON SIZE INCOME STATEMENT OF HLL
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