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Classification and Interpretation of Financial Ratios

Financial ratios are critical tools used in the analysis of financial statements to gain insight into a company's operational efficiency, profitability, financial stability, and cash flow health. Here is a breakdown of essential financial ratios across different categories.

Liquidity Ratios

1. Current Ratio

  • Formula: Current Assets / Current Liabilities
  • Interpretation: Measures a company's ability to pay off its short-term liabilities with its short-term assets. A higher ratio indicates better liquidity and financial health.

2. Quick Ratio (Acid Test Ratio)

  • Formula: (Cash + Marketable Securities + Receivables) / Current Liabilities
  • Interpretation: Assesses a company's ability to meet short-term obligations without relying on the sale of inventories. A standard quick ratio is 1:1.

Capital Structure Ratios (Solvency Ratios)

1. Debt-Equity Ratio

  • Formula: Total Long-term Debts / Shareholders' Equity
  • Interpretation: Indicates the proportion of company financing that comes from creditors and investors. A lower ratio suggests less leverage and a greater ability to meet obligations.

2. Proprietary Ratio

  • Formula: Shareholders' Funds / Total Assets
  • Interpretation: Reflects the proportion of a company’s total assets financed by shareholders. Higher values suggest better long-term financial solvency.

3. Interest Coverage Ratio

  • Formula: Earnings Before Interest and Taxes (EBIT) / Fixed Interest Charges
  • Interpretation: Measures how easily a company can pay interest on outstanding debt. Higher ratios indicate better financial health.

4. Capital Gearing Ratio

  • Formula: Fixed Income Securities / Equity Shareholders' Funds
  • Interpretation: Indicates the financial leverage of a company. A higher ratio implies higher risk, associated with higher debt levels.

Turnover Ratios (Activity Ratios)

1. Inventory Turnover Ratio

  • Formula: Cost of Goods Sold / Average Inventory
  • Interpretation: Shows how many times inventory is sold and replaced over a period. Higher ratios indicate efficient inventory management.

2. Debtors Turnover Ratio

  • Formula: Net Credit Sales / Average Debtors
  • Interpretation: Measures how quickly cash is collected from customers. A higher ratio suggests efficient credit and collection processes.

3. Fixed Assets Turnover Ratio

  • Formula: Sales / Net Fixed Assets
  • Interpretation: Reflects the efficiency with which fixed assets are used to generate sales. Higher ratios indicate better utilization of fixed assets.

4. Capital Turnover Ratio

  • Formula: Sales / Total Capital Employed
  • Interpretation: Measures the efficiency of capital utilization. A higher ratio indicates effective use of capital.

Profitability Ratios

1. Gross Profit Ratio

  • Formula: (Gross Profit / Net Sales) * 100
  • Interpretation: Indicates the percent of total sales revenue that exceeds the cost of goods sold. A higher ratio suggests better production efficiency.

2. Net Profit Ratio

  • Formula: (Net Profit / Net Sales) * 100
  • Interpretation: Measures the overall profitability after accounting for all expenses and income. Higher percentages reflect better profitability.

3. Operating Ratio

  • Formula: (Cost of Goods Sold + Operating Expenses) / Net Sales
  • Interpretation: Shows the efficiency of operation management. Lower ratios are indicative of better operational efficiency.

4. Operating Profit Ratio

  • Formula: (Operating Net Profit / Net Sales) * 100
  • Interpretation: Measures the percentage of profit made from operations before taxes and interest. Higher values demonstrate operational efficiency.

5. Return on Investment (ROI)

  • Formula: (Net Profit Before Interest and Taxes / Total Capital Employed) * 100
  • Interpretation: Indicates the effectiveness in generating profits from invested capital. Higher ROI shows efficient use of capital.

6. Return on Shareholders' Funds (or Equity)

  • Formula: (Net Profit After Interest and Taxes / Shareholders' Funds) * 100
  • Interpretation: Reflects the return on the money invested by shareholders. Higher ratios are preferable as they indicate better profitability.

7. Earnings Per Share (EPS)

  • Formula: (Net Profit After Taxes - Preference Dividend) / Number of Equity Shares
  • Interpretation: Indicates how much profit is earned per share of stock. Higher EPS values are typically viewed as more favorable.

8. Dividend Payout Ratio

  • Formula: Dividend Per Share / Earnings Per Share
  • Interpretation: Measures the percentage of earnings distributed as dividends. Lower ratios may indicate the company is reinvesting more into growth.

9. Dividend Yield Ratio

  • Formula: Dividend Per Share / Market Price Per Share
  • Interpretation: Measures the return on investment from dividends. Higher values suggest better income from dividends relative to the share price.

10. Price-Earning Ratio (P/E Ratio)

  • Formula: Market Price Per Share / Earnings Per Share
  • Interpretation: Indicates how much investors are willing to pay per dollar of earnings. Higher P/E ratios suggest investors expect higher earnings growth in the future.

This guide offers a thorough understanding of various financial ratios, providing insights into a company's financial operations, efficiency, and profitability.

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