Which financial ratios are better to be high and low? (1 Viewer)

[plexor]

as we're often asked to interpret the calculation we get, which ratios are better to be a high number and which are better to be a low number?
e.g. current ratio usually should be 2:1 or greater....

with the net profit ratio/return on owners' equity ratio/expense ratio etc, what's a usual figure going to be around? e.g. is it better to have a high or low percentage?

 

[seano77]

I think a higher expense ratio is bad.
When solvency increases this is bad (more debt).
When liquidity increases this is good (more assets to liabilities)
Net profit is better to be higher (greater level of NP for sales)
Gross profit ratio is better higher.
Obviously the longer number of days it takes to collect acc. receivables the worse the problem.
Return on Owners Equity is better higher because this means a greater return (net profit) for each dollar of owners equity.

Feel free to correct me..

 

[russianROULETTE]

When solvency increases this is bad (more debt).

not always. i was revising this earlier and my textbook said if you have more debt because you're taking advantage of cash during good economic times, it's generally okay, but if that doesn't get turned into cash you might not be able to pay debts, and in bad economic times it's bad.

 

[RohanZ]

I think the issue here is, what kind of area would a ratio be considered 'good'. e.g a NPR of 14%

 

[seano77]

Yeah but I think the OP wants to know when they compare to an industry average whehter the calculation they get is healthy in comparison to the average or not..

 

[plexor]

^^ Yeah. Haha.

 

[Rampager]

I think a higher expense ratio is bad.
When solvency increases this is bad (more debt).
When liquidity increases this is good (more assets to liabilities)
Net profit is better to be higher (greater level of NP for sales)
Gross profit ratio is better higher.
Obviously the longer number of days it takes to collect acc. receivables the worse the problem.
Return on Owners Equity is better higher because this means a greater return (net profit) for each dollar of owners equity.

Feel free to correct me..

Quoting this cause its 100% correct.

Although it might be wise to consider if the current ratio is TOO far above the industry average, that the business should scale back on its current assets and use some of the Cash in Bank to pay off its long-term debts. Being liquid is good, but being TOO liquid shows either: bad management of funds or too much unsold stock.

 

[uebel]

ok guys i need some help with solvency/ gearing/ debt:equity ratio.


one textbook says

long-term debt
owners equity

and the other says

Total liabilities
Owners equity

which is it???

thanks guys

 

[seano77]

For solvency I use Total Liabilities÷Owners Equity.

 

[Rampager]

Exactly what it says on the box, debt to equity, total liabilities/OE.

 

[michael1990]

as we're often asked to interpret the calculation we get, which ratios are better to be a high number and which are better to be a low number?
e.g. current ratio usually should be 2:1 or greater....

with the net profit ratio/return on owners' equity ratio/expense ratio etc, what's a usual figure going to be around? e.g. is it better to have a high or low percentage?

If you have it greater than 2:1, it actually means you have cash tied up in places where it is not utilised. Eg. 8:1, stuck in inventory.
This is why the ideal ratio is 2:1.

 

[michael1990]

I think a higher expense ratio is bad.
When solvency increases this is bad (more debt).
When liquidity increases this is good (more assets to liabilities)
Net profit is better to be higher (greater level of NP for sales)
Gross profit ratio is better higher.
Obviously the longer number of days it takes to collect acc. receivables the worse the problem.
Return on Owners Equity is better higher because this means a greater return (net profit) for each dollar of owners equity.

Feel free to correct me..

This is incorrect.
When solvency increases it just means 'A company's ability to meet its financial obligations on time'. So if it increases it is actually better for the company.

 

[plexor]

But solvency = gearing = debt:equity.

And as a rule of thumb it's generally bad to have more debt finance than equity finance?

 

[seano77]

This is incorrect.
When solvency increases it just means 'A company's ability to meet its financial obligations on time'. So if it increases it is actually better for the company.

But solvency is about debt and equity, not about meeting financial obligations. Given that a greater solvency ratio may be good because the business can utilise the finance to expand, but you don't want it to get up into the 80% range. Maybe you have it confused with liquidity?

 

[michael1990]

But solvency is about debt and equity, not about meeting financial obligations. Given that a greater solvency ratio may be good because the business can utilise the finance to expand, but you don't want it to get up into the 80% range. Maybe you have it confused with liquidity?

Incorrect.
It is a measure of the business's long-term financial stability. It gives an indication of how risk it is to buy shares or invest in the business, so owners and shares will be most interested in the gearing ratio. The higher the ratio or percentage, the more financially unstable the business is. A business at risk will have a high level leverage, be highly geared and a low level of solvency. As a general rule a business should have more equity than debt so that ideal level of gearing is 3:2 or 66%

 

[Rampager]

edit: I just realised I said the exact same thing as you, nevermind.

Although it would be wise to note you flipped the ratios, instead of debt:equity in your 3:2, example, you have it as equity:debt.

wait... do you? Or am I reading that wrong?

 

[seano77]

He meant 2:3.

 

[michael1990]

He meant 2:3.

Yes sorry this is what i meant.

But do you now understand?

 

[seano77]

Yeah thanks I just always thought solvency and gearing were the same thing, but in actuality they have somewhat of an inverse relationship. That is when a company is more highly geared their ability to meet long-term financial commitments is decreased, ie solvency is reduced. Right?

 

[michael1990]

Yeah thanks I just always thought solvency and gearing were the same thing, but in actuality they have somewhat of an inverse relationship. That is when a company is more highly geared their ability to meet long-term financial commitments is decreased, ie solvency is reduced. Right?

Perfect.

Because due to the fact that a highly geared business has more debt and is less financially stable. And solvency refers to a business's ability to turn assets into cash.