It’s not an easy task to invest in any of the companies in Dubai. You should know about the status of the company that you are investing in comparison to other businesses. You are loaded with questions when you think of investing. Financial ratio analysis is the answer to all the questions that you have in your mind. Initially you get confused with a number of financial ratios. The key is to take the right ratios provided that you have knowledge about those.
What are financial ratios?
Financial ratios are nothing but the process of combining two or more numbers in different ways. The numbers are generally taken from the balance sheet or the financial statement. Financial ratios indicate the profitability, efficiency and solvency of a business. While the profitability ratio conveys the ease with which the business is going to make profit, the solvency ratio depicts the way the business is going to meet its financial obligation in time bound manner. The efficiency ratio determines the way the business is going to show positive outcomes with sales and profits.
Some of the basic terms that you should know while doing financial ratio analysis
1. Cost of the goods sold
This is a measure of the direct purchases made by a company for doing specific jobs. This can include the cost of labour, material, subcontractors, equipment and any other expenses.
This is also a kind of expense which doesn’t include any depreciation of value. This type of expense includes all sorts of administrative expenses.
3. Unpaid invoices
This is the amount of money that your customers owe you as you have provided services to them.
4. Unpaid bills
This is the amount of money that you need to pay your vendors for the equipments that they have provided you to manufacture your goods.
5. Current assets
These are assets which can be converted in to money in one year. These assets include amount of cash, prior expenses, the amount you are going to receive, inventory and other assets which can be easily converted in to money.
6. Current liabilities
These are the debts which you should pay within one year. Taxes, amount of money payable, debts for a short term, notes, withholdings and other liabilities come in this category.
7. Working capital
When you subtract the current liabilities from current assets you get the value of working capital.
Some of the financial ratios that help you in financial analysis
Two profitability ratios
1. Net profit margin
This is the amount of return on sales. This is the profit which you get before paying taxes. The higher amount of net profit margin is healthy for businesses. This helps you stand out in the cut-throat market which low prices competitors dominate. You can calculate the ratio by dividing the net profit before taxed with net sales. You can convert in to percentage by multiplying 100 with it. While industry average in Dubai stands 4 percent, you can increase this ratio to 10 percent for maintaining a healthy profile.
2. Net profit to total assets
This is a ratio of return on assets. This is the most important ratio that shows how much profit a company is making. This ratio is calculated by knowing the value of profit after paying taxes. The higher is the percentage, the higher is the profit percentage of the company. You can calculate the ratio by dividing the net profit after taxes with total assets value.
You will get the value in percentage by multiplying the number with 100. When you reach 15 percent, the ratio indicates that you have a well run company.
1. Current ratio
This ratio is indicative of the value of the current assets to meet the current liabilities. When you have this ratio value as 2 your company is termed as a healthy company. This ratio varies from standard of company to company. A sloe selling company needs high current ratio. You can calculate this ratio by dividing the current assets by current liabilities.
2. Quick ratio
This ratio depends upon the liquidity of your current assets. This ratio also measures the ease with which your current assets can be converted in to cash to cover up the current liabilities. This is a hot favourite ratio of the lenders. You can calculate this ratio by dividing the cash plus current receivables with the current liabilities. A number more than 1.35 is a good indicator.
3. Total liabilities to total assets
The value of this ratio above 1.25 indicates that your company is able to absorb the operating losses to meet the financial obligations. You can divide total liabilities by total assets to find this number.
4. Working capital to total assets
As the name of the ratio suggests, this ratio indicates the percentage of the assets in the form of working capital. To easily meet the liabilities, you can convert the working capital in to cash. You can find the ratio by dividing the current assets with working capital. A value of 0.25 or greater is good for a business.
5. Cash to current liabilities
This ratio is also known as doomsday ratio. When you have to meet the current financial obligations, your business should be prepared for this. This ratio can be found out by dividing the cash by current liabilities. This is the most crucial solvency ratios of all. When this value is equal to 1, your business is said to have good doomsday ratio.
This ratio is a measure of how easily you can collect the amount receivable by your business. The standard time period is 10 or 15 days in Dubai. This ratio can be calculated by dividing the average accounts receivable with sales. Then you need to multiply 365 with the outcomes. When this ratio goes below 40, the efficiency ratio of a company becomes better.
Sales to total labour ratio
This ratio is indicative of the expenses on the labour from the amount of profit that you earn. You can get this number by dividing labour cost plus labour expenses with sales. You can convert the number in to percentage by multiplying 100 with it. A percentage below 30 is a good indicator for a company.
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When you analyse these ratios, you get an overall idea of a business. You can easily decide whether to invest in a company or not.