Liquidity and Profitability Ratios

Liquidity Ratios

• Liquidity ratios help assess a company's ability to cover its short-term obligations.
• Current Ratio = Current Assets / Current Liabilities.
• A high current ratio (>2) suggests strong liquidity but may indicate inefficient asset use.
• A low current ratio (<1) may point to liquidity issues and difficulty in meeting short-term debts.
• Quick Ratio = (Current Assets - Inventory) / Current Liabilities.
• A high quick ratio (>1.0) indicates good short-term liquidity.
• A low quick ratio (<1.0) implies dependency on inventory to cover liabilities.
• Cash Ratio = (Cash + Marketable Securities) / Current Liabilities.
• A high cash ratio (>1.0) indicates very strong liquidity but potential underutilization of assets.
• A low cash ratio (<0.2) suggests potential difficulty in meeting immediate obligations.

Profitability Ratios

• Profitability ratios measure a company's ability to generate earnings relative to its revenue, assets, and equity.
• Gross Profit Margin = (Gross Profit / Revenue) × 100.
• A high gross profit margin (>40%) indicates strong profitability.
• A low gross profit margin (<20%) suggests high costs of goods sold (COGS) are reducing profits.
• Operating Profit Margin = (Operating Profit / Revenue) × 100.
• A high operating profit margin (>15%) suggests strong core business profitability.
• A low operating profit margin (<5%) suggests weak operational efficiency.
• Net Profit Margin = (Net Income / Revenue) × 100.
• A high net profit margin (>10%) indicates strong overall profitability.
• A low net profit margin (<5%) suggests high expenses or weak pricing power.
• ROA (Return on Assets) = (Net Income / Total Assets) × 100.
• A high ROA (>10%) signifies efficient asset utilization.
• A low ROA (<5%) indicates inefficient use of assets.
• ROE (Return on Equity) = (Net Income / Shareholders' Equity) × 100.
• A high ROE (>15%) means good returns for investors.
• A low ROE (<10%) suggests poor shareholder returns.

Efficiency Ratios

• Efficiency ratios evaluate how well a company utilizes its assets and manages its liabilities.
• Inventory Turnover = Cost of Goods Sold (COGS) / Average Inventory.
• High inventory turnover (>6) means fast-moving inventory.
• Low inventory turnover (<2) suggests slow inventory movement and possible obsolescence.
• Accounts Receivable Turnover = Net Credit Sales / Average Accounts Receivable.
• High accounts receivable turnover (>10) indicates customers pay quickly.
• Low accounts receivable turnover (<5) indicates slow collection and potential bad debts.

Leverage Ratios

• Leverage ratios assess the extent to which a company uses debt to finance its assets.
• D/E Ratio (Debt-to-Equity Ratio) = Total Debt / Total Equity.
• A high D/E ratio (>2.0) implies high financial risk.
• A low D/E ratio (<0.5) indicates conservative financing.
• Interest Coverage = EBIT (Earnings Before Interest and Taxes) / Interest Expense.
• High interest coverage (>3.0) means comfortable debt servicing.
• Low interest coverage (<1.5) indicates risk of financial distress.

Valuation Ratios

• Valuation ratios are used to determine the relative value of a company.
• P/E Ratio (Price-to-Earnings Ratio) = Market Price per Share / Earnings per Share (EPS).
• A high P/E ratio (>20) may indicate an expensive stock, potentially overvalued.
• A low P/E ratio (<10) indicates an undervalued stock or weak growth potential.

DuPont Analysis

• ROE (Return on Equity) = Net Income / Equity.
• Profitability = Net Income / Sales
• To increase profitability: Increase the price or lower the cost.
• Enter new markets or introduce new products (diversification).
• Efficiency = Sales / Assets
• To increase efficiency: Decrease assets by decreasing inventory (Just-In-Time methodology).
• Leverage = Assets / Equity
• To increase leverage: Increase assets by increasing accounts receivable (selling on credit).
• Decrease equity by distributing dividends.
• Increase in liabilities will increase A/E (Assets/Equity).

Financial Reporting Standards

• GAAP (Generally Accepted Accounting Principles) and IFRS (International Financial Reporting Standards) are two key sets of standards.
• US GAAP is created by the FASB and monitored by the US SEC.
• IFRS is created by the IASB and is monitored by IOSCO.

Financial Statements

• Balance Sheet: Total Assets (what the entity owns) = Total Liabilities (what the entity owes) + Total Equity.
• Assets are listed from most liquid to least liquid.
• Income Statement: Net Income = Revenues – Expenses.
• Statement of Cash Flow: CFO (operating), CFI (investing), CFF (financing).
• An annual report includes a narrative section and a financial section.
• The narrative section contains CEO/CFO letters and management's analysis.
• The financial section includes audited financial statements, summaries, and auditor's report.

Fraud Triangle

• The Fraud Triangle consists of:
• Rationalization: Justifying the fraud.
• Incentive: Pressure or motivation.
• Opportunity: Conditions that allow fraud.