1.

Gross Profit Margin

The gross profit margin tells us the profit a company makes on its cost of sales, or cost of
goods sold. In other words, it indicates how efficiently management uses labor and supplies
in the production process.
Gross Profit Margin = (Sales - Cost of Goods Sold)/Sales
Suppose that a company has $1 million in sales and the cost of its labor and materials
amounts to $600,000. Its gross margin rate would be 40% ($1 million - $600,000/$1
million).

Companies with high gross margins will have a lot of money left over to spend on other
business operations, such as research and development or marketing, so be on the lookout for
downward trends in the gross margin rate over time. This is a telltale sign of future problems
facing the bottom line. When labor and material costs increase rapidly, they are likely to
lower gross profit margins - unless, of course, the company can pass these costs onto
customers in the form of higher prices.

It's important to remember that gross profit margins can vary drastically from business to
business and from industry to industry. For instance, the airline industry has a gross margin
of about 5%, while the software industry has a gross margin of about 90%.


Net Profit Margin interpretation
Net profit margin is a key financial indicator used to asses the profitability of a company.
Net profit margin formula is:

Net profit margin measures how much of each dollar earned by the company is
translated into profits. A low profit margin indicates a low margin of safety: higher risk that a
decline in sales will erase profits and result in a net loss.
Net profit margin provides clues to the company's pricing policies, cost structure and
production efficiency. Different strategies and product mix cause the net profit margin to vary
among different companies.
Net profit margin is an indicator of how efficient a company is and how well it controls its
costs. The higher the margin is, the more effective the company is in converting revenue into
actual profit.
Net profit margin is mostly used to compare company's results over time. To compare net
profit margin, even between companies in the same industry, might have little meaning. For
example, if a company recently took a long-term loan to increase its production capacity, the net
profit margin will significantly be reduced. That does not mean, necessarily, that the company is
less efficient than other competitors.
ROCE is used to prove the value the business gains from its assets and liabilities. A
business which owns lots of land will have a smaller ROCE compared to a business which
owns little land but makes the same profit.
It basically can be used to show how much a business is gaining for its assets, or how much
it is losing for its liabilities.
Drawbacks of ROCE[edit]
The main drawback of ROCE is that it measures return against the book value of assets in
the business. As these are depreciated the ROCE will increase even though cash flow has
remained the same. Thus, older businesses with depreciated assets will tend to have higher
ROCE than newer, possibly better businesses. In addition, while cash flow is affected by
inflation, the book value of assets is not. Consequently revenues increase with inflation
while capital employed generally does not (as the book value of assets is not affected by
inflation)).

Current ratio

Definition
If you ask a panel of experienced entrepreneurs or business experts why most businesses fail, you will
likely notice the same answer coming up over and over -- one of the biggest reasons businesses fail is
because they don't have enough cash on hand to satisfy their short term operating expenses. These
businesses may have had a great idea, a great location, and some great people on their team; but they
didn't manage their short-term cash needs effectively and failed. When accountants, top-level
executives, and financial analysts want to make sure a company is on solid ground, there are a few
quick things they can look at. One of those financial metrics is known as a current ratio.
The current ratio is a measure of how well a company can meet its short-term obligations. Short-term
obligations are usually debts or liabilities that need to be paid in the next twelve months.
In accounting terms, the current ratio is the ratio of current assets to current liabilities, and is often
described as the liquidity of a company. To be classified as a current asset, the asset must be cash or
able to be easily converted into cash in the next 12 months. Current liabilities are any amounts that are
owed in the next 12 months. For a more advanced understanding, we recommend additional study of the
individual components (which are mentioned below) that make up current assets and current liabilities.
It is important to note that the current ratio may also be referred to as aliquidity ratio or working
capital ratio.
Formula
The current ratio formula is calculated as follows:
Current Assets/Current Liabilities
Current Assets = Cash + Accounts Receivable + Inventory + Prepaid Expenses
Current Liabilities = Short-term notes payable + Accounts Payable + Payroll Liabilities + Unearned
Revenue
Analysis
In the most simple terms, the current ratio helps internal and external individuals see how likely the
company is to have issues paying its bills. Remember, this is one of the main reasons companies fail!
The higher the current ratio, the better positioned the company is to operate smoothly in the future and
have no issues paying their bills in the next 12 months.
A ratio over 1 means that a company has some cushion to handle potential unforeseen expenses that
might arise. As an employee, looking at the current ratio might be a good idea to let you know whether
your future paychecks are safe! A ratio under 1 implies that if all the bills over the next 12 months came
due immediately, the company would not be able to pay them all off; only a percentage of them. To get
a better idea of this in action, let's look at an example.
If a company's current assets are $100,000 and its current liabilities are $50,000, the current ratio is 2:1.
This means that if all the bills for the next year came due tomorrow (totaling $50,000), the company
could pay them all off twice (with its $100,000 in assets). This gives investors and managers assurance
that the company is in a good position to pay the bills.
Continue reading...














Limitations of Financial Ratio Analysis:


1) False Results:
If Financial Statements are not correct Financial Ratio
Analysis will also be correct.

2) Different meanings are put on different terms:
Elements and sun-elements are not uniquely defined. An
enterprise may work out ratios on the basis of profit after Tax
and interest while others work on profit before interest and
Tax .So, the Ratios will also be different so cannot be
compared. But before comparison is to be done the basis for
calculation of ratio should be same.

3) Not comparable if different firms follow different
accounting Policies.
Two enterprises may follow different Policies like some
enterprises may charge depreciation at straight line basis
while others charge at diminishing value. Such differences
may adversely affect the comparison of the financial
statements.

4) Affect of Price level changes:
Normally no consideration is given to price level changes in
the accounting variables from which ratios are computed. Changes in price level affects the
comparability of Ratios.
This handicaps the utility of accounting ratios.

5) Ignores qualitative factors:
Financial Ratios are on the basis of quantitative analysis
only. But many times qualitative facts overrides quantitative
aspects .For Example: Loans are given on the basis of
accounting Ratios but credit ultimately depends on the
character and managerial ability of the borrower. Under such
circumstances, the conclusions derived from ratio analysis
would be misleading.

6) Ratios may be worked out for insignificant and unrelated
figures.
Example: A ratio may be worked out for sales and
investment in govt. securities. Such ratios will only be
misleading. Care should be exercised to work out ratios
between only such figures which have cause and effect
relationship. One should be reasonably clear as to what is the
cause and what is the effect.
7) Difficult to evolve a standard Ratio:
It is very difficult to evolve a standard ratio acceptable at all
times as financial and economic scenario are dynamic. Again
the underlying conditions for different firms and different
industries are not similar, so an acceptable standard ratio
cannot be evolved.
8) Window Dressing:
Financial Ratios will be affected by window dressing.
Manipulations and window dressings affect the financial
statements so they are going to affect the f. ratios also.
Therefore a particular ratio may not be a definite indicator of
good or bad management.
9) Personal Bias:
Ratios have to be interpreted, but different people may
interpret same ratios in different ways. Ratios are only tools of financial analysis but personal judgment
of the analyst is
more important. If he does not posses requisite qualifications
or is biased in interpreting the ratios, the conclusion drawn
prove misleading.

http://agbssem1.webs.com/accounting/Financial%20Ratio%20Analysis%20I.pdf







Explain the limitations of ratio analysis.


LIMITATIONS OF RATIO ANALYSIS

The reader of financial statements must understand the basic limitations associated with
ratio analysis. As analytical tools, ratios are attractive because they are simple and
convenient. But too frequently, decisions are based on only these simple computations.
The ratios are only as good as the data upon which they are based and the information
with which they are compared.

One important limitation of ratios is that they are based on historical cost, which can
lead to distortions in measuring performance. By failing to incorporate changing
price information, many believe that inaccurate assessments of the enterprise's financial
condition and performance result.

Also, investors must remember that where estimated items (such as depreciation
and amortization) are significant, income ratios lose some of their
credibility. Income recognized before the termination of the life of the business is an
approximation. In analyzing the income statement, the user should be aware of the
uncertainty surrounding the computation of net income. As one writer aptly noted, "The
physicist has long since conceded that the location of an electron is best expressed by
a probability curve. Surely an abstraction like earnings per share is even more subject
to the rules of probability and risk."
10


Probably the greatest criticism of ratio analysis is the difficult problem of achieving
comparability among firms in a given industry. Achieving comparability among firms
requires that the analyst (1) identify basic differences existing in their accounting
principles and procedures and (2) adjust the balances to achieve comparability.

Basic differences in accounting usually involve one of the following areas:
1. Inventory valuation (FIFO, LIFO, average cost).
2. Depreciation methods, particularly the use of straight-line versus accelerated
depreciation.
3. Capitalization versus expense of certain costs, particularly costs involved in developing
natural resources.
4. Pooling versus purchase in accounting for business combinations.
5. Capitalization of leases versus noncapitalization.
6. Investments in common stock carried at equity, and fair value.
7. Differing treatments of postretirement benefit costs.
8. Questionable practices of defining discontinued operations, impairments, and
extraordinary items.

The use of these different alternatives can make a significant difference in the ratios computed.
For example, in the brewing industry, at one time Anheuser-Busch noted that if it had used
average cost for inventory valuation instead of LIFO, inventories would have increased
approximately $33,000,000. Such an increase would have a substantive impact on the current
ratio. Several studies have analyzed the impact of different accounting methods on financial
statement analysis. The differences in income that can develop are staggering in some
cases.
11
The average investor may find it difficult to grasp all these differences, but investors
must be aware of the potential pitfalls if they are to be able to make the proper adjustments.

Finally, it must be recognized that a substantial amount of important information is not included
in a company's financial statements. Events involving such things as industry changes,
management changes, competitors' actions, technological developments, government actions,
and union activities are often critical to a company's successful operation. These events occur
continuously, and information about them must come from careful analysis of financial reports in
the media and other sources. Indeed many argue, under what is known as the efficient market
hypothesis, that financial statements contain "no surprises" to those engaged in market
activities. They contend that the effect of these events is known in the marketplace and the price
of the company's stock adjusts accordingly well before the issuance of such reports.






http://www.wiley.com/college/kieso/0471363049/dt/analysttool/faprimer/fap09.htm






LIMITATIONS OF RATIO ANALYSIS
When interpreting accounting ratios, students
should always bear in mind the following:
Comparative information is essential for
any meaningful ratio analysis. A lack of
information about either industry averages
or previous years performance will
severely limit analysis.
Accounting ratios are based on income
statements/profit and loss accounts
and balance sheets, both of which are
subject to the limitations of historical cost
accounting. Inflation, differing bases for
valuing assets, or specific price changes
can distort inter-company comparisons,
and comparisons made over time.
Ratio analysis helps to build a picture of
a company. The richness of the picture
depends on the quality of the financial
information on which the ratios are based.
If the accounts are poorly constructed (eg
poor estimates of depreciation, bad debts
etc) then conclusions drawn from the
accounting ratios will be flawed.
Past company performance is not
necessarily the best indicator of future
performance. Indeed, by the time accounts
are published and available for analysis
they may already be out of date.