Financial statement of a company contains mere figures. Absolute figures are useful but they
do not convey much meaning. In terms of accounting ratios, comparison of these related
figures makes them meaningful. Ratio Analysis gives a better understanding of the financial
condition and performance of a business concern. It also helps in comparing the financial
condition of the company with peer companies.
According to Myers, ratio analysis is a "study of relationship among the various financial
factors in a business “
Professional Confectioners’s financial ratios are much below the industry average. compared
to last year, the current year has shown a negative trend that is it is lower than last year and if
the company continues to work like this then company will finally be much more below the
industrial average. Banks are not willing to lend to Professional Confectioners because their
short term as well as long term debt paying capacity is not very attractive.
Financial ratios are useful indicators of a firm's performance and financial situation.
Professional Confectioners has to immediately find ways to improve its financial health.
Meaning of each financial ratio is explained to Pehr Weisengraf . Some recommendations are
given how can Professional Confectioners can improve its financial health and so can make
financial ratios attractive. Unless its financial ratios look attractive to the lenders, they will find
it difficult to arrange fund.
Ratio analysis is an excellent method for determining the overall financial condition of a
company. It puts the information from a financial statement into perspective, helping to spot
financial patterns and helps the company in finding weak areas and what should be done to
improve financial health of the company.
Financial ratios can be classified according to the information they provide. The
following types of ratios frequently are used:
Financial leverage ratios
These broadly classified ratios contain many ratios.
* Current ratio
* Liquid /Acid test / Quick ratio
* Inventory/Stock turnover ratio
* Debtors/Receivables turnover ratio
* Average collection period
* Creditors/Payable turnover ratio
* Working capital turnover ratio
* Fixed assets turnover ratio
* Over and under trading
Financial Leverage ratios or long term solvency ratios:
* Debt equity ratio
* Proprietary or Equity ratio
* Ratio of fixed assets to shareholders funds
* Ratio of current assets to shareholders funds
* Interest coverage or debt service ratio
* Capital gearing ratio
* Over and under capitalization
* Gross profit ratio
* Net profit ratio
* Operating ratio
* Expense ratio
* Return on shareholders investment or net worth
* Return on equity capital
* Return on capital employed (ROCE) ratio
* Dividend yield ratio
* Dividend payout ratio
* Earnings Per Share Ratio
* Price earning ratio
Bankers are mainly interested in liquidity ratios and financial leverage ratios.
Banker has calculated some ratios and based on these ratios banker has decided to not to lend
to the company. Meaning of each of the ratios calculated by the banker are given below:
Current ratio and Quick Ratio are liquidity ratios and throws light at liquidity position of the
company and whether company can honor short term debt obligations or not.
Current Ratio: Current ratio tells whether company is able to meet its current obligations by
measuring if it has enough assets to cover its liabilities. The standard current ratio for a healthy
business is two, meaning it has twice as many assets as liabilities.
Professional Confectioners’s current ratio is 1.7 which is below standard current ratio as well
as industry average (2.4). It indicates that company is facing liquidity crunch and may not be
able to meet short term debt obligations.
Current Ratio = Current Assets / Current Liabilities.
Quick Ratio: Tthe quick ratio (also called acid test ratio) measures a business' liquidity it
excludes inventories when counting assets as inventories can not be converted to cash quickly
always. It calculates a business' liquid assets in relation to its liabilities. The higher the ratio is,
the higher your business' level of liquidity. The optimal quick ratio is 1 or higher.
Professional Confectioners’s Quick ratio is 0.4 which is below standard current ratio as well as
industry average (0.8). It too indicates that company is facing liquidity crunch and may not be
able to meet short term debt obligations.
Quick Ratio = (Current Asset – Inventory) / Current Liability
Debt Ratio: Debt ratio is a financial leverage ratio. Financial leverage ratios provide an
indication of the long-term solvency of the firm. Lower the debt ratio, better the long term
solvency position of the company.
Debt Ratio = Total Debt / Total Asset
Company’s debt ratio is 0.89 as compared to industry average of 0.65. Company’s debt ratio
increased from 0.81 to 0.89 this year. It indicates that company’s debt is increasing and debt as
a percentage of asset is more as compared to industry.
Debt to Net Worth Ratio : Debt to net worth ratio used in the analysis of financial statements
to show the amount of protection available to creditors.
Debt to Net Worth Ratio = Total liabilities / Total stock holder’s equity
A high ratio usually indicates that the business has a lot of risk because it must meet principal
and interest on its obligations.
Professional Confectioners’s Debt to Net Worth Ratio is 2.9 as compared to industry average
1.9. It indicates that company has a lot of risk because it must meet principal and interest on its
Inventory Turnover Ratio: Inventory turnover ratio tells how often company’s inventory
turns over during the course of the year. Because inventories are the least liquid form of asset,
a high inventory turnover ratio is generally positive. But unusually high ratio as compared to
the industry average means company is losing sales because of inadequate stock on hand.
Professional Confectioners’s Inventory Turnover Ratio is 4.3 times/year as compared to
industry average of 7.1 times/year . It means company’s inventory is not moving fast enough.
Inventory Turnover Ratio= Cost of Good sold/Average inventory
Collection Period: Average collection period indicates how quickly your customers are paying
. Ideally, the average collections period should less than credit terms plus 15 days.
Collection Period= Accounts Receivable X 365 days
Professional Confectioners’s collection period is 43 days as compared to industry average of
34 days. It indicates customers are not paying quickly. Company should ensure than customers
should pay on time.
Net Sales to Working Capital Ratio: This ratio measures the number of times accounts
receivable turn over during the year. The higher the turnover of receivables, the shorter the
time between sale and cash collection. High Net Sales to Working Capital Ratio is good for the
Net Sales to Working Capital Ratio = Sales / Net Working Capital
Net Working capital = Current asset – Current liabilities
Professional Confectioners’s Net Sales to Working Capital Ratio is 9.7 as compared to industry
average of 12.6. This indicates that company has scope to improve the time between sale and
Net profit on sales ratio and Net Profit to Equity Ratio are Profitability ratios. These ratios
provide the information about the company's bottom line (Net Profit).
Net Profit on Sales Ratio: Net Profit on Sales Ratio is defined as Profit after tax divided by
Sales. This ratio is used to is used to measure the overall profitability. It also indicates the
firm's capacity to face adverse economic conditions such as price competition . Higher the ratio
the better is the profitability.
Professional Confectioners’s Net Profit on Sales Ratio is 3.8 as compared to industry average
of 9.4. Obviously company is not as profitable as other companies in the industry are.
Net Profit to Equity Ratio: The profit to equity ratio measures the rate of return on
If this return is low, then the capital could be better employed elsewhere.
Professional Confectioners’s is 18.3 as compared to industry average of 13.4. It means
company is giving more return to the equity holders as compared to other companies in the
A look at all these ratios shows that financial ratios of Professional Confectioners are much
below the industrial average. It is also clear that as compared to last year, the current year has
shown a negative trend that is it is lower than last year. And if the company continues to work
like this then company will finally be much more below the industrial average. Only place
where Professional Confectioners outperformed the peers is Net profit to Equity ratio.
Company’s ability to meet short term debt obligations is not very good (evident from current
ratio and quick ratio). Also, company’s long term solvency is not as good as peers have
(evident from Debt ratio and Debt to net worth ratio). Inventory is not moving fast, customers
are not paying at time, company’s profitability is not at par with peers.
It seems company is struggling and owner MUST do something immediately to improve the
financial health of the company.
Professional Confectioners ‘s current assets is reducing from the last year and to the
industry average or current liabilities are on an upward trend, which is a negative effect on
company. So, he should first of all try to improve his current assets. Unless current ratio
and quick ratio are improved, bankers will not lend the company.
There should be minimum required stock and owner should maintain a proper
communication between the suppliers and customers that is he should maintain proper
justing time approach. Also, company should ensure that inventory moves faster.
Customers are not paying at time. Company must devise strict credit policy and should
have a better collection mechanism in place.
Company should avoid taking debt for sometime as debt ratio is very high. When debt
ratio comes down to industry average, bankers will feel safe to lend to the company.