Financial ratio analysis 2

Welcome back to my blog. Yesterday, we started our discussion on ratio analysis, we highlighted its importance and the types available. We also mentioned the questions one must ask while doing these ratios to guide interpretation and use of results. However, we were only able to explain one of the ratios – liquidity ratio. Now let us continue with explanation of the other types of ratio and how to interpret them.

Leverage ratio

This category of ratio compares the total of each category of the balance sheet items. This last sentence most likely bring to your mind the accounting equation; do you still remember that equation? I trust you do. The accounting equation is Assets equals liabilities plus owner’s equity.

Given the above, leverage ratio appraises the company’s ability to use its resources (assets) to meet its obligations both short term and long term (total liabilities) on one hand. And on the other hand, it establishes the relationship between borrowed funds (liabilities) and owners’ funds (equity).

In my own opinion, this category of ratio is more important to creditors. The creditors will want to know if the company’s resources can pay them back. And in the instance of losses, or poor use of resources, can they rely on owners’ funds?

Common ratios used in this category include:

1. Debt ratio: This type of leverage ratio shows if the company’s resources can meet its total obligations. To calculate it, we use total debt divided by total assets. The farther it is from 1, the better. Simply put, the result should be less than 1.
2. Gearing ratio: This leverage ratio shows the relative position of the creditors and owners in terms of financing the company. To calculate we use total debt divided by shareholders’ equity. Where the result is more than 1, it means the company rely more on debt for financing than owners equity; and where it is below 1, the company owners’ are financing more than debt.

Kindly note that, in the instance of capital structure, we can use a more selective measure of the proportion of debt as long term debt divided by capitalization. Here, capitalization is equal to long term or non-current liabilities and shareholders’ equity. In essence, instead of using total debt as indicated in number 2 above, we can streamline to only long term debt.

Activity ratio

This category of ratio appraises funds management in relation to how long it takes to tie down funds in inventory, get funds from debtors (account receivables) and how long it takes to settle creditors (account payable).

Common ratios in this category include:

1. Average collection period: This ratio measures how long it takes to convert credit sales (account receivables) to cash. That is It relates account receivable to credit sales made during a year. We calculate this as Account receivable divided by credit sales multiplied by 360days or 365days. When doing this ratio, it is important to know the general credit terms granted to customer in the industry under review. Where the collection period calculated is different from the norm, it may be a warning signal especially where it tends to be slower.

We will continue from here next week. Thanks for your time.

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