Liquidity Ratio A class of financial metrics that is used to determine a company's ability to pay off its short-terms debts

obligations. This is done by comparing a company's most liquid assets or those that can be easily converted to cash, its short-term liabilities. Generally, the higher the value of the ratio, the larger the margin of safety that the company possesses to cover short-term debts. Common liquidity ratios include the current ratio, the quick ratio and the operating cash flow ratio.

Current Ratio The current ratio is a popular financial ratio used to test a company's liquidity by deriving the proportion of current assets available to cover current liabilities. The concept and purpose behind this ratio is to ascertain whether a company's short-term assets such as cash, cash equivalents, marketable securities, receivables and inventory are readily available to pay off its short-term liabilities such as notes payable, current portion of term debt, payables, accrued expenses and taxes. In theory, the higher the current ratio, the better. Formula:

Quick Ratio The quick ratio, also known as the quick assets ratio or the acid-test ratio is a liquidity indicator that further refines the current ratio by measuring the amount of the most liquid current assets there are to cover current liabilities. The quick ratio is more conservative than the current ratio because it excludes inventory and other current assets, which are more difficult to turn into cash. Therefore, a higher ratio means a more liquid current position.

Formula:

Cash Ratio The cash ratio is an indicator of a company's liquidity that further refines both the current ratio and the quick ratio by measuring the amount of cash, cash equivalents or invested funds there are in current assets to cover current liabilities. The cash ratio is the most inflexible and conservative of the three shortterm liquidity ratios which is current, quick and cash ratios. Formula:

Profitability Ratio In this section, we will look at important profit margins, which display the amount of profit a company generates on its sales at the different stages of an income statement. It is these ratios that can give insight into the all important "profit". In the income statement, there are four levels of profit or profit margins - gross profit, operating profit, pretax profit and net profit. The term "margin" can apply to the absolute number for a given profit level and/or the number as a percentage of net sales/revenues. The objective of margin analysis is to detect consistency or positive/negative trends in a company's earnings.

Gross profit margin A company's cost of sales, or cost of goods sold, represents the expense related to labor, raw materials and manufacturing overhead involved in its production process. This expense is deducted from the company's net sales/revenue, which results in a company's first level of profit, or gross profit. The gross profit margin is used to analyze how efficiently a company is using its raw materials, labor and manufacturing-related fixed assets to generate profits. A higher margin percentage is a favorable profit indicator. Formula:

Operating profit margin The operating profit margin ratio indicates how much profit a company makes after paying for variable costs of production such as wages, raw materials. Operating profit margin ratio analysis measures a companys operating efficiency and pricing efficiency with its successful cost controlling. The higher the ratio, the better a company is. A higher operating profit margin means that a company has lower fixed cost and a better gross margin or increasing sales faster than costs. Formula:

Return on capital employed The return on capital employed (ROCE) ratio, expressed as a percentage, complements the return on equity (ROE) ratio by adding a company's debt liabilities, or funded debt, to equity to reflect a company's total "capital employed". This measure narrows the focus to gain a better understanding of a company's ability to generate returns from its available capital base. The return on capital employed is an important measure of a company's profitability. Formula:

Return on asset This ratio indicates how profitable a company is relative to its total assets. The return on assets (ROA) ratio illustrates how well management is employing the company's total assets to make a profit. The higher the return, the more efficient management is in utilizing its asset base. The ROA ratio is calculated by comparing net income to average total assets, and is expressed as a percentage. Formula:

Return on equity This ratio indicates how profitable a company is by comparing its net income to its average shareholders' equity. The return on equity ratio (ROE) measures how much the shareholders earned for their investment in the company. The higher the ratio percentage, the more efficient management is in utilizing its equity base and the better return is to investors. The ROE ratio is an important measure of a

company's earnings performance. The ROE tells common shareholders how effectively their money is being employed. Formula:

Efficiency Ratio Ratios that are typically used to analyze how well a company uses its assets and liabilities internally. Efficiency Ratios can calculate the turnover of receivables, the repayment of liabilities, the quantity and usage of equity and the general use of inventory and machinery. Some common ratios are accounts receivable turnover, fixed asset turnover, sales to inventory, sales to net working capital, accounts payable to sales and stock turnover ratioAlso, efficiency ratios are important because an improvement in the ratios usually translate to improved profitability.

Receivables turnover An accounting measure used to quantify a firm's effectiveness in extending credit as well as collecting debts. The receivables turnover ratio is an activity ratio, measuring how efficiently a firm uses its assets. A high turnover ratio is generally a good thing since it means that customers are paying their bills on time. If the turnover ratio is too high as compared to the industry the company is in, it may mean, however, that the company is too restrictive in its credit and collection policies and not extending credit to enough customers. Formula:

Inventory turnover The inventory-turnover ratio gives a general view on the inventories of a company. In order to calculate it you should divide the annual sales of the company by its inventory. The result represents the turnover or inventory or how many times inventory was used and then again replaced. The purpose of understand why inventory turnover is important because the owner needs to look at the company's investment in inventory and determine what inventory is being most productive. Formula:

Total assets turnover Total Asset Turnover ratio indicates the effectiveness of the firm's use of its total asset base. Beyond analyzing a firm's total asset base, it is useful to focus on fixed assets, receivables and inventories in order to evaluate Total Asset Turnover ratio. The higher the ratio of sales to net total assets, the better. Formula: Total Asset Turnover = Sales/Net Total Assets

Recievables turnover An accounting measure used to quantify a firm's effectiveness in extending credit as well as collecting debts. The receivables turnover ratio is an activity ratio, measuring how efficiently a firm uses its assets.

Formula:

Limitations of Ratio Analysis 1. Accounting Information Different Accounting Policies The choices of accounting policies may distort inter company comparisons. Example a company allows valuation of assets to be based on either revalued amount or at depreciated historical cost. The business may choose not to revalue its asset because by doing so the depreciation charge is going to be high and will result in lower profit. Creative accounting The businesses apply creative accounting in trying to show the better financial performance or position which can be misleading to the users of financial accounting. Like the company mentioned above, requires that if an asset is revalued and there is a revaluation deficit, it has to be charged as an expense in income statement, but if it results in revaluation surplus the surplus should be credited to revaluation reserve. So in order to improve on its profitability level the company may select in its revaluation programme to revalue only those assets which will result in revaluation surplus leaving those with revaluation deficits still at depreciated historical cost.

2. Information problems

 Ratios are not definitive measures Ratios need to be interpreted carefully. They can provide clues to the companys performance or financial situation. But on their own, they cannot show whether performance is good or bad. Ratios require some quantitative information for an informed analysis to be made. Outdated information in financial statement The figures in a set of accounts are likely to be at least several months out of date, and so might not give a proper indication of the companys current financial position. Historical costs not suitable for decision making Where historical cost convention is used, asset valuations in the balance sheet could be misleading. Ratios based on this information will not be very useful for decision making. Financial statements contain summarised information Ratios are based on financial statements which are summaries of the accounting records. Through the summarisation some important information may be left out which could have been of relevance to the users of accounts. The ratios are based on the summarised year end information which may not be a true reflection of the overall years results. Interpretation of the ratio It is difficult to generalise about whether a particular ratio is good or bad. For example a high current ratio may indicate a strong liquidity position, which is good or excessive cash which is bad. Similarly Non current assets turnover ratio may denote either a firm that uses its assets efficiently or one that is under capitalised and cannot afford to buy enough assets.

3. Comparison of performance over time Price changes Inflation renders comparisons of results over time misleading as financial figures will not be within the same levels of purchasing power. Changes in results over time may show as if the enterprise has improved its performance and position when in fact after adjusting for inflationary changes it will show the different picture.

 Technology changes When comparing performance over time, there is need to consider the changes in technology. The movement in performance should be in line with the changes in technology. For ratios to be more meaningful the enterprise should compare its results with another of the same level of technology as this will be a good basis measurement of efficiency. Changes in Accounting policy Changes in accounting policy may affect the comparison of results between different accounting years as misleading. The problem with this situation is that the directors may be able to manipulate the results through the changes in accounting policy. This would be done to avoid the effects of an old accounting policy or gain the effects of a new one. It is likely to be done in a sensitive period, perhaps when the businesss profits are low. Changes in Accounting standard Accounting standards offers standard ways of recognising, measuring and presenting financial transactions. Any change in standards will affect the reporting of an enterprise and its comparison of results over a number of years. Impact of seasons on trading As stated above, the financial statements are based on year end results which may not be true reflection of results year round. Businesses which are affected by seasons can choose the best time to produce financial statements so as to show better results. For example, a tobacco growing company will be able to show good results if accounts are produced in the selling season. This time the business will have good inventory levels, receivables and bank balances will be at its highest. While as in planting seasons the company will have a lot of liabilities through the purchase of farm inputs, low cash balances and even nil receivables.

4. Inter-firm comparison Different financial and business risk profile No two companies are the same, even when they are competitors in the same industry or market. Using ratios to compare one company with another could provide misleading information. Businesses may be within the same industry

but having different financial and business risk. One company may be able to obtain bank loans at reduced rates and may show high gearing levels while as another may not be successful in obtaining cheap rates and it may show that it is operating at low gearing level. To un informed analyst he may feel like company two is better when in fact its low gearing level is because it can not be able to secure further funding. Different capital structures and size Companies may have different capital structures and to make comparison of performance when one is all equity financed and another is a geared company it may not be a good analysis. Impact of Government influence Selective application of government incentives to various companies may also distort intercompany comparison. One company may be given a tax holiday while the other within the same line of business not, comparing the performance of these two enterprises may be misleading.

Ratio analysis is useful, but analysts should be aware of these problems and make adjustments as necessary. Ratios analysis conducted in a mechanical, unthinking manner is dangerous, but if used intelligently and with good judgement, it can provide useful insights into the firms operations. Besides that, there are other limitation while doing ratio analysing: Ratio do not tell us what is going right or wrong they merely invite qiestion,tell us what has happened but not why. Ratio relate to past or to a moment in time but not to the future Ratio are only as reliable as underlying data Ratio analysis is based on accounting not economic data

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REFERENCE
1. http://hiox.org/12893-limitation-of-ratio-analysis.php 2. www.investopedia.com 3. http://www.stock-market-investors.com 4. http://bizfinance.about.com

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