As a manager of a business organization, there are some questions you want to ask about the business such as:
- Is the business growing?
- How liquid is the business?
- How profitable is the business?
- What is our level of risk?
- How efficient are we in using our assets to generate revenue?
Ratio analysis is an expression of one number to another number and they give indications of what is going on in an organization. For example, if the gross margin of a company is high, it is indicating something. Ratios on their own are meaningless unless we have a benchmark to compare (industry average). In the absence of a benchmark, we can use a trend. For example, the Return on Equity (ROE) of a bank is 10% last year 5% Ratio analysis can be used by a manager to compare the weakness and strengths of his organization with various companies.
TYPES OF RATIO ANALYSIS
WORKING CAPITAL RATIO: This is the management of your current assets and current liabilities. If we say your business is liquid or profitable your working capital can also be a factor. The goal of working capital management is to ensure that a firm is able to continue its operations and it has sufficient ability to satisfy both maturing short-term debt and upcoming operational expenses. The management of working capital involves managing inventories, account receivables, payables, and cash. Working capital helps you avoid Running out of cash (borrowing) and running out of inventory (losing customers).
Working Capital Ratio = Current Assets – Current Liabilities/Current Liabilities
LEVERAGE: The cost of borrowing for a company is guided by International Accounting Standard (IAS) 23. When you borrow, do not borrow for consumption but borrow for investment. It is about debt and when we are talking about debt, we must match short-term assets plus short-term liability because short-term liability you are expected to pay within one year. There is good and bad debt, bad debt is the loan you take and you do not invest in it.
Leverage also known as Gearing Measures, is the proportion of assets involved invested in a business that is financed by outsiders (long-term borrowing). Leverage tells you how risky a business is. Hence, the Leverage Ratio can also be called Gearing Ratio. A figure of 0.5 or less is ideal. In other words, not more than half of the company’s assets should be financed by debt.
Leverage ratio = Total Debt/Equity
Ways to reduce gearing of a company
- The company should focus on profit improvement. For example, cost minimization.
- Repay long-term loans
- Retain profits rather than pay dividends.
- Issue more shares
- Convert loans into equity
Ways to increase gearing of a company
- Focus on growth, and invest in revenue growth rather than profit.
- Convert short-term debt into long-term loans
- Buy back ordinary shares
- Pay increased dividends out of retained earnings
- Issue preference shares or debenture
Interest Coverage Ratio: The interest coverage ratio is used to determine how easily a company can pay its interest expenses on outstanding debt.
Interest Coverage Ratio = EBIT/Interest Expenses
In conclusion, we also have the Sustainable Growth Rate (SGR) which is used to access the maximum rate at which a company can grow without looking for external funding.
SGR = Profit After Tax X Retention Ratio (RR)/Equity
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