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RATIO MEANING Profitability ratios

CHANGE

LIMITATIONS

USED BY sHareholde rs board managers

Gross profit Margin

Looks ate cost of goods sold as a %

Inc: better company

Misunderstood Doesnt include all costs Its not profit

Operating profit margin Net profit margin

Looks at PBIT as a % of sales Measures profitability after all expenses are considered as a % Inc: a company is more efficient

at converting sales into actual profit.


A higher value of return on capital employed is favorable indicating that the company generates more earnings per dollar of capital employed. A lower value of ROCE indicates lower profitability. A company having less assets but same profit as its competitors will have higher value of return on capital employed and thus higher profitability.

ROCE

amount of funds employed from capital in making profits.

Ignores the time value of money

ROE Measures the return of money the investors have put in the company.

Higher values are generally favorable meaning that the company is efficient in generating income on new investment. Investors should compare the ROE of different companies and also check the trend in ROE over time. However, relying solely on ROE for investment decisions is not safe. It can be artificially influenced by the management, for example, when debt financing is used to reduce share capital there will be an increase in ROE even if income remains constant.

does not take into consideration how much debt a company has or whether the company has utilized a stock buyback to lower shareholder equity.

ROA Measures the efficiency in which the company is Inc: show that business is more
profitable. indicates that the profitability of

An ROA depends on the company, the industry and the

managing investements in assets and using them to generate profit

the company is improving. Dec: means that profitability is deteriorating.

economic environment. the total assets are based on theCV of the assets, not the market value. If there is a large discrepancy between the carrying and market value of the assets, the ratio could provide misleading numbers. Bank Lenders Manageme nt

LIQUIDITY RATIOS Current Ratio

A companys ability to repay liability


Current ratio below 1 shows critical liquidity problems because it means that total current liabilities exceed total current assets. higher the current ratio better it is but there is a limit to this. Abnormally high value of current ratio may indicate existence of idle or underutilized resources in the company.

Used to test the ability of a company to pay the liability of a business within a year.

does not focus on the quality of the current assets and so called the crude ratio. does not tell anything about the profitability of the company.

Quick ratio

measures the ability of a company to pay its debts by using its cash and near cash current assets (i.e. accounts receivable and marketable securities).

The higher the better position of the comp.

ignores timing of both cash received and cash paid

EFFICIENCY RATIOS Inventory turnover (days)


an activity ratio measuring the number of times per period, a business sells and replaces its entire batch of inventory again. Higher: indicates better performance Lower: means inefficiency in controlling inventory levels. May also be an indication of overstocking which may pose risk of obsolescence and increased inventory holding costs. However, a very high value of

Banks Lenders Manageme nt

this ratio may be accompanied by loss of sales due to inventory shortage.

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