Analyze financial ratios

1. Profitability Ratios

• Gross Profit Margin:
  • Formula: Gross Profit / Revenue
  • Data: Gross Profit = $15 million, Revenue = $50 million
  • Calculation: $15M / $50M = 30%
  • Interpretation: The gross profit margin of 30% indicates that Company XYZ retains 30 cents from every dollar of revenue after accounting for the cost of goods sold. This is a solid margin, suggesting good control over production costs or effective pricing strategies.
• Net Profit Margin:
  • Formula: Net Income / Revenue
  • Data: Net Income = $5 million, Revenue = $50 million
  • Calculation: $5M / $50M = 10%
  • Interpretation: A net profit margin of 10% indicates that Company XYZ retains 10 cents for every dollar of revenue after accounting for all expenses. This is a healthy margin, demonstrating efficient cost management and operational effectiveness.

2. Liquidity Ratios

• Current Ratio:
  • Formula: Current Assets / Current Liabilities
  • Data: Current Assets = $30 million, Current Liabilities = $20 million
  • Calculation: $30M / $20M = 1.5
  • Interpretation: A current ratio of 1.5 means that Company XYZ has $1.50 in current assets for every $1.00 in current liabilities. This indicates good short-term financial health and suggests the company should be able to meet its short-term obligations without difficulty.
• Quick Ratio:
  • Formula: (Current Assets – Inventories) / Current Liabilities
  • Data: Current Assets = $30 million, Inventories = $10 million, Current Liabilities = $20 million
  • Calculation: ($30M – $10M) / $20M = 1.0
  • Interpretation: A quick ratio of 1.0 indicates that Company XYZ has just enough liquid assets (excluding inventory) to cover its short-term liabilities. This is a neutral position, meaning the company can meet its obligations but doesn’t have significant excess liquidity.

3. Efficiency Ratios

• Inventory Turnover Ratio:
  • Formula: Cost of Goods Sold (COGS) / Average Inventory
  • Data: COGS = $25 million, Average Inventory = $10 million
  • Calculation: $25M / $10M = 2.5
  • Interpretation: An inventory turnover of 2.5 means the company sells and replaces its inventory 2.5 times per year. This suggests a relatively moderate inventory management process. If the company can improve its inventory turnover, it could enhance efficiency and reduce holding costs.
• Receivables Turnover Ratio:
  • Formula: Revenue / Average Accounts Receivable
  • Data: Revenue = $50 million, Average Accounts Receivable = $5 million
  • Calculation: $50M / $5M = 10
  • Interpretation: A receivables turnover of 10 indicates that the company collects its receivables 10 times per year, or approximately once every 36 days. This suggests efficient management of receivables and effective credit policies.

4. Solvency Ratios

• Debt-to-Equity Ratio:
  • Formula: Total Debt / Shareholders’ Equity
  • Data: Total Debt = $40 million, Shareholders’ Equity = $60 million
  • Calculation: $40M / $60M = 0.67
  • Interpretation: A debt-to-equity ratio of 0.67 indicates that Company XYZ is using 67 cents of debt for every dollar of equity. This is a moderate level of leverage, suggesting the company has a balanced approach to financing. It is not overly reliant on debt, but it still uses some leverage to fund its operations.
• Interest Coverage Ratio:
  • Formula: EBIT (Earnings Before Interest and Taxes) / Interest Expense
  • Data: EBIT = $10 million, Interest Expense = $2 million
  • Calculation: $10M / $2M = 5
  • Interpretation: An interest coverage ratio of 5 means the company earns five times its interest expense, indicating that it comfortably generates enough earnings to cover interest payments. This is a strong indicator of solvency and financial stability.