Omkar Anvekar

Financial Management

Q1) Importance and Uses of Ratio Analysis

1)Analysis of Financial Statements Interpretation of the financial statements and data is essential for all
internal and external stakeholders of the firm. With the help of ratio analysis, we interpret the numbers from
the balance sheet and income statements. Every stakeholder has different interests when it comes to the result
from the financial like the equity investors are more interested in the growth of the dividend payments and the
earnings power of the organization in the long run. Creditors would like to ensure that they get their repayments
on their dues on time.
2) Profitability of the Company Profitability ratios help to determine how profitable a firm is. Return on
Assets and Return on Equity helps to understand the ability of the firm to generate earnings. Return on assets is
the total net income divided by total assets. It means how many does a company earn a profit for every dollar of
its assets. Return on equity is net income by shareholders equity. This ratio basically tells us how well a company
uses its investors’ money. Ratios like the Gross profit and Net profit margin. Margins help to analyze the firm’s
ability to translate sales to profit.
3)Analysis of Operational Efficiency of the Firms Certain ratios help us to analyze the degree of efficiency of
the firms. Ratios like account receivables turnover, fixed asset turnover, and inventory turnover ratio. These ratios
can be compared with the other peers of the same industry and will help to analyze which firms are better
managed as compared to the others. It measures a company’s capability to generate income by using the assets.
It looks at various aspects of the firm like the time it generally takes to collect cash from debtors or the time
period for the firm to convert the inventory to cash. This is why efficiency ratios are very important, as an
improvement will lead to a growth in profitability.
4) Liquidity of the Firms Liquidity determines whether the company can pay its short-term obligations or not. By
short-term obligations, we mean the short term debts which can be paid off within 12 months or within
the operating cycle. For example the salaries due, sundry creditors, tax payable, outstanding expenses
etc. Current ratio, quick ratio are used to measure the liquidity of the firms
5)Identifying the Business Risks of the Firm One of the most important reasons to use ratio analysis is that it
helps in understanding the business risk of the firm. Calculating the leverages (Financial Leverage and Operating
Leverages) helps the firm understand the business risk i.e. how sensitive the profitability of the company is with
respect to its fixed cost deployment as well as debt outstanding.

Q2) Factors Affecting Working Capital

1)Nature of Business: The requirement of working capital depends on the nature of business. The
nature of business is usually of two types: Manufacturing Business and Trading Business. In the case
of manufacturing business it takes a lot of time in converting raw material into finished goods.
Therefore, capital remains invested for a long time in raw material, semi-finished goods and the
stocking of the finished goods.Consequently, more working capital is required. On the contrary, in
case of trading business the goods are sold immediately after purchasing or sometimes the sale is
affected even before the purchase itself. Therefore, very little working capital is required. Moreover,
in case of service businesses, the working capital is almost nil since there is nothing in stock

2) Scale of Operations: There is a direct link between the working capital and the scale of operations.
In other words, more working capital is required in case of big organisations while less working
capital is needed in case of small organisations.

3) Business Cycle: The need for the working capital is affected by various stages of the business
cycle. During the boom period, the demand of a product increases and sales also increase.
Therefore, more working capital is needed. On the contrary, during the period of depression, the
demand declines and it affects both the production and sales of goods. Therefore, in such a situation
less working capital is required.

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4) Seasonal Factors: Some goods are demanded throughout the year while others have seasonal
demand. Goods which have uniform demand the whole year their production and sale are
continuous. Consequently, such enterprises need little working capital.On the other hand, some
goods have seasonal demand but the same are produced almost the whole year so that their supply
is available readily when demanded.Such enterprises have to maintain large stocks of raw material
and finished products and so they need large amount of working capital for this purpose. Woolen
mills are a good example of it.

5) Production Cycle: Production cycle means the time involved in converting raw material into
finished product. The longer this period, the more will be the time for which the capital remains
blocked in raw material and semi-manufactured products.Thus, more working capital will be
needed. On the contrary, where period of production cycle is little, less working capital will be
needed.

6) Credit Allowed: Those enterprises which sell goods on cash payment basis need little working
capital but those who provide credit facilities to the customers need more working capital.

7) Raw Material: Availability of raw material also influences the amount of working capital. If the
enterprise makes use of such raw material which is available easily throughout the year, then less
working capital will be required, because there will be no need to stock it in large quantity.On the
contrary, if the enterprise makes use of such raw material which is available only in some particular
months of the year whereas for continuous production it is needed all the year round, then large
quantity of it will be stocked. Under the circumstances, more working capital will be required.

8) Growth Prospects:Growth means the development of the scale of business operations (production,
sales, etc.). The organisations which have sufficient possibilities of growth require more working
capital, while the case is different in respect of companies with less growth prospects.

Q3) Sources of Working Capital

1. Loans from Commercial Banks:

Small-scale enterprises can raise loans from the commercial banks with or without security. This method of
financing does not require any legal formality except that of creating a mortgage on the assets. Loan can be paid
in lump sum or in parts. The short-term loans can also be obtained from banks on the personal security of the
directors of a country.Such loans are known as clean advances. Bank finance is made available to small- scale
enterprises at concessional rate of interest. Hence, it is generally a cheaper source of financing working capital
requirements of enterprise. However, this method of raising funds for working capital is a time-consuming
process.
2. Public Deposits:

Often companies find it easy and convenient to raise short- term funds by inviting shareholders, employees and
the general public to deposit their savings with the company. It is a simple method of raising funds from public for
which the company has only to advertise and inform the public that it is authorised by the Companies Act 1956,
to accept public deposits.Public deposits can be invited by offering a higher rate of interest than the interest
allowed on bank deposits. However, the companies can raise funds through public deposits subject to a
maximum of 25% of their paid up capital and free reserves.
3. Trade Credit:

Just as the companies sell goods on credit, they also buy raw materials, components and other goods on credit
from their suppliers. Thus, outstanding amounts payable to the suppliers i.e., trade creditors for credit purchases
are regarded as sources of finance. Generally, suppliers grant credit to their clients for a period of 3 to 6 months.
Thus, they provide, in a way, short- term finance to the purchasing company. As a matter of fact, availability of
this type of finance largely depends upon the volume of business. More the volume of business more will be the
availability of this type of finance and vice versa.

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Yes, the volume of trade credit available also depends upon the reputation of the buyer company, its financial
position, degree of competition in the market, etc. However, availing of trade credit involves loss of cash discount
which could be earned if payments were made within 7 to 10 days from the date of purchase of goods. This loss
of cash discount is regarded as implicit cost of trade credit.
4. Factoring:

Factoring is a financial service designed to help firms in managing their book debts and receivables in a better
manner. The book debts and receivables are assigned to a bank called the 'factor' and cash is realised in
advance from the bank. For rendering these services, the fee or commission charged is usually a percentage of
the value of the book debts/receivables factored.
This is a method of raising short-term capital and known as 'factoring'. On the one hand, it helps the supplier
companies to secure finance against their book debts and receivables, and on the other, it also helps in saving
the effort of collecting the book debts.
The disadvantage of factoring is that customers who are really in genuine difficulty do not get the opportunity of
delaying payment which they might have otherwise got from the supplier company.

In the present context where industrial sickness is spreading like an epidemic, the reason for which particularly in
SSI sector being delayed payments from their suppliers; there is a clear-cut rationale for introduction of factoring
system. There has been some progress also on this front.

The recommendations of the Study Group (RBI 1996) to examine the feasibility of setting up of factoring
organisations in the country, under the Chairmanship of Shri C. S. Kalyanasundaram have been accepted by the
Government of India. The Group is of the view that factoring for SSI units could prove to be mutually beneficial to
both Factors and SSI units and Factors should make every effort to orient their strategy to crystallize the potential
demand from the sector.
5. Discounting Bills of Exchange:

When goods are sold on credit, bills of exchange are generally drawn for acceptance by the buyers of goods. The
bills are generally drawn for a period of 3 to 6 months. In practice, the writer of the bill, instead of holding the bill
till the date of maturity, prefers to discount them with commercial banks on payment of a charge known as
discount.
The term 'discounting of bills' is used in case of time bills whereas the term, 'purchasing of bills' is used in respect
of demand bills. The rate of discount to be charged by the bank is prescribed by the Reserve Bank of India (RBI)
from time to time. It generally amounts to the interest for the period from the date of discounting to the date of
maturity of bills.

If a bill is dishonoured on maturity, the bank returns the dishonoured bill to the company who then becomes liable
to pay the amount to the bank. The cost of raising finance by this method is the amount of discount charged by
the bank. This method is widely used by companies for raising short-term finance.
6. Bank Overdraft and Cash Credit:

Overdraft is a facility extended by the banks to their current account holders for a short-period generally a week.
A current account holder is allowed to withdraw from its current deposit account upto a certain limit over the
balance with the bank. The interest is charged only on the amount actually overdrawn. The overdraft facility is
also granted against securities.

Cash credit is an arrangement whereby the commercial banks allow borrowing money up to a specified-limit
known as 'cash credit limit.' The cash credit facility is allowed against the security. The cash credit limit can be
revised from time to time according to the value of securities. The money so drawn can be repaid as and when
possible.

The interest is charged on the actual amount drawn during the period rather on limit sanctioned. The rate of
interest charged on both overdraft and cash credit is relatively higher than the rate of interest given on bank
deposits. Arranging overdraft and cash credit with the commercial banks has become a common method adopted
by companies for meeting their short- term financial, or say, working capital requirements.

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Q4)Short Notes

1)Liquidity Ratio Liquidity ratios are an important class of financial metrics used to determine a debtor's ability
to pay off current debt obligations without raising external capital. Liquidity ratios measure a company's ability to
pay debt obligations and its margin of safety through the calculation of metrics including the current ratio, quick
ratio, and operating cash flow ratio. Current liabilities are analyzed in relation to liquid assets to evaluate the
coverage of short-term debts in an emergency. Liquidity is the ability to convert assets into cash quickly and
cheaply. Liquidity ratios are most useful when they are used in comparative form. This analysis may be
internal or external

For example, internal analysis regarding liquidity ratios involves using multiple accounting periods that are
reported using the same accounting methods. Comparing previous time periods to current operations allows
analysts to track changes in the business. In general, a higher liquidity ratio shows a company is more liquid and
has better coverage of outstanding debts.

Alternatively, external analysis involves comparing the liquidity ratios of one company to another or an entire
industry. This information is useful to compare the company's strategic positioning in relation to its competitors
when establishing benchmark goals. Liquidity ratio analysis may not be as effective when looking across
industries as various businesses require different financing structures. Liquidity ratio analysis is less effective for
comparing businesses of different sizes in different geographical locations.

2) Sources of Finance Sources of finance for business are equity, debt, debentures, retained earnings, term
loans, working capital loans, letter of credit, euro issue, venture funding etc. These sources of funds are used in
different situations. They are classified based on time period, ownership and control, and their source of
generation. It is ideal to evaluate each source of capital before opting for it. Sources of capital are the most
explorable area especially for the entrepreneurs who are about to start a new business. It is perhaps the toughest
part of all the efforts. There are various capital sources, we can classify on the basis of different parameters.
Having known that there are many alternatives to finance or capital, a company can choose from. Choosing the
right source and the right mix of finance is a key challenge for every finance manager. The process of selecting
the right source of finance involves in-depth analysis of each and every source of fund. For analyzing and
comparing the sources, it needs the understanding of all the characteristics of the financing sources. There are
many characteristics on the basis of which sources of finance are classified.

Long-Term Sources of Finance

Long-term financing means capital requirements for a period of more than 5 years to 10, 15, 20 years or maybe
more depending on other factors. Capital expenditures in fixed assets like plant and machinery, land and building
etc of a business are funded using long-term sources of finance. Part of working capital which permanently stays
with the business is also financed with long-term sources of funds. Long-term financing sources can be in form of
any of them:

Medium Term Sources of Finance

Medium term financing means financing for a period of 3 to 5 years and is used generally for two reasons. One,
when long-term capital is not available for the time being and second when deferred revenue expenditures like
advertisements are made which are to be written off over a period of 3 to 5 years.

Short Term Sources of Finance Short term financing means financing for a period of less than 1 year. The
need for short-term finance arises to finance the current assets of a business like an inventory of raw material
and finished goods, debtors, minimum cash and bank balance etc. Short-term financing is also named as working
capital financing.

3) Wealth maximization
Wealth maximization is the concept of increasing the value of a business in order to increase the value of
the shares held by stockholders. The concept requires a company's management team to continually search
for the highest possible returns on funds invested in the business, while mitigating any associated risk of
loss. This calls for a detailed analysis of the cash flows associated with each prospective investment, as well
as constant attention to the strategic direction of the organization.The most direct evidence of wealth
maximization is changes in the price of a company's shares. For example, if a company spends funds to
develop valuable new intellectual property, the investment community is likely to recognize the future positive
cash flows associated with this new property by bidding up the price of the company's shares. Similar
reactions may occur if a business reports continuing increases in cash flow or profits.The concept of wealth
maximization has been criticized, since it tends to drive a company to t ake actions that are not always in the
best interests of its stakeholders, such as suppliers, employees, and local communities. For example:

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A company may minimize its investment in safety equipment in order to save cash, thereby putting workers at
risk.

A company may continually pit suppliers against each other in the unmitigated pursuit of the lowest possible
parts prices, resulting in some suppliers going out of business.

A company may only invest minimal amounts in pollution controls, resulting in environmental damage to the
surrounding area.

Because of these types of issues, senior management may find it necessary to back away from the sole
pursuit of wealth maximization, and instead pay attention to other issues, as well. The result is likely to be a
modest reduction in shareholder wealth.Given the issues noted here, wealth maximization should be
considered just one of the goals that a company must attend to, rather than its only goal.

4) Net Present Value is the difference between the present value of cash inflows and the present value of cash
outflows over a period of time. NPV is used in capital budgeting and investment planning to analyze the
profitability of a projected investment or project.
1)A positive net present value indicates that the projected earnings generated by a project or investment - in
present dollars - exceeds the anticipated costs, also in present dollars. It is assumed that an investment with a
positive NPV will be profitable, and an investment with a negative NPV will result in a net loss. This concept is the
basis for the Net Present Value Rule, which dictates that only investments with positive NPV values should be
considered.

Breaking Down Net Present Value

Money in the present is worth more than the same amount in the future due to inflation and to earnings from
alternative investments that could be made during the intervening time. In other words, a dollar earned in the
future won’t be worth as much as one earned in the present. The discount rate element of the NPV formula is a
way to account for this.

Net present value (NPV) is the calculation used to find today’s value of a future stream of payments. It accounts
for the time value of money and can be used to compare investment alternatives that are similar. The NPV relies
on a discount rate of return that may be derived from the cost of the capital required to make the investment, and
any project or investment with a negative NPV should be avoided. An important drawback of using an NPV
analysis is that it makes assumptions about future events that may not be reliable

5) Debt-to-Equity Ratio The debt-to-equity (D/E) ratio is calculated by dividing a company’s total liabilities by its
shareholder equity. These numbers are available on the balance sheet of a company’s financial statements.The
ratio is used to evaluate a company's financial leverage. The D/E ratio is an important metric used in corporate
finance. It is a measure of the degree to which a company is financing its operations through debt versus wholly
owned funds. More specifically, it reflects the ability of shareholder equity to cover all outstanding debts in the
event of a business downturn.

Given that the debt-to-equity ratio measures a company’s debt relative to the value of its net assets, it is most
often used to gauge the extent to which a company is taking on debt as a means of leveraging its assets. A high
debt/equity ratio is often associated with high risk; it means that a company has been aggressive in financing its
growth with debt.

If a lot of debt is used to finance growth, a company could potentially generate more earnings than it would have
without that financing. If leverage increases earnings by a greater amount than the debt’s cost (interest), then
shareholders should expect to benefit. However, if the cost of debt financing outweighs the increased income
generated, share values may decline. The cost of debt can vary with market conditions. Thus, unprofitable
borrowing may not be apparent at first.

Changes in long-term debt and assets tend to have the greatest impact on the D/E ratio because they tend to be
larger accounts compared to short-term debt and short-term assets. If investors want to evaluate a company’s
short-term leverage and its ability to meet debt obligations that must be paid over a year or less, other ratios will
be used.

he debt-to-equity ratio can be applied to personal financial statements as well, in which case it is also known as
the personal debt-to-equity ratio. Here, “equity” refers to the difference between the total value of an individual’s
assets and the total value of his/her debt or liabilities.

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6) Cost of Debt Cost of debt refers to the effective rate a company pays on its current debt. In most cases, this
phrase refers to after-tax cost of debt, but it also means the company's cost of debt before taking taxes into
account. The difference in cost of debt before and after taxes lies in the fact that interest
expenses are deductible.

Calculate the Cost of Debt

To calculate after-tax cost of debt, subtract a company's effective tax rate from 1, and multiply the difference by
its cost of debt. Do not use the company's marginal tax rate; rather, add together the company's state and federal
tax rate to ascertain its effective tax rate.

For example, if a company's only debt is a bond it has issued with a 5% rate, its pre-tax cost of debt is 5%. If its
tax rate is 40%, the difference between 100% and 40% is 60%, and 60% of 5% is 3%. The after-tax cost of debt
is 3%.

The rationale behind this calculation is based on the tax savings the company receives from claiming its interest
as a business expense. To continue with the above example, imagine the company has issued $100,000 in
bonds at a 5% rate. Its annual interest payments are $5,000. It claims this amount as an expense, and this
lowers the company's income on paper by $5,000. As the company pays a 40% tax rate, it saves $2,000 in taxes
by writing off its interest. As a result, the company only pays $3,000 on its debt. This equates to a 3% interest
rate on its debt.

Calculate the Cost of Debt After Taxes

To calculate after-tax cost of debt, subtract a company's effective tax rate from 1, and multiply the difference by
its cost of debt. Do not use the company's marginal tax rate; rather, add together the company's state and federal
tax rate to ascertain its effective tax rate.

For example, if a company's only debt is a bond it has issued with a 5% rate, its pre-tax cost of debt is 5%. If its
tax rate is 40%, the difference between 100% and 40% is 60%, and 60% of 5% is 3%. The after-tax cost of debt
is 3%

7) Inter firm analysis

Inter firm comparison means a comparison of two or more similar business units with the objective of finding
the competitive position to improve the profitability and productivity of those business units. Thus, inter firm
comparison is a tool used by the management of a company to compare its operating performance and
financial results with those of similar companies engaged in the same industry.

Definition of Inter-firm Comparison

According to Centre for Inter-firm Comparison, established by the British Institute of Management, Inter firm
Comparison is concerned with the industrial firm, its success and the part played by the management in
achieving it. The end product of a properly conducted inter firm comparison is not a statistical survey but the flash
of insight in the mind of meaning director of the firm which has taken part in such an exercise. The results of this
give him an instant and vivid picture of how his firm’s profitability, its costs, its stock turnover, and other key
factors affecting the success of a business compares with other firms in his industry. The way in which the
results of inter firm comparisons are presented to him makes him see clearly where his firm is weaker or stronger
than its competitors; what weaknesses call for his own attention, what possibilities of improving those
weaknesses or reinforcing the firm’s strength he should explore; in what respects the general objectives and
specific targets of the firms should be changed.

Meaning of Intra-firm comparison

Intra-firm comparison means comparison of two or more departments or divisions of the same business
unit with the objective of meaningful analysis in order to improve the operational efficiency of all the departments
or divisions.
Both, the inter firm comparison and intra-firm comparison have the same objectives. The comparison may cover
the financial position or operating results or both.

Need for Inter-firm & Intra-firm comparison

The survival and growth of any business unit are based on the competitive strength. The competitive strength is
based on the financial position and solvency of the company. Some ratios are calculated to find out the
financial position and solvency. A business unit can get success in market by knowing the strength and
weakness of other similar business units. In this situation, there is a need of inter-firm comparison. Besides, a

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business unit can identify the strength of its various departments and divisions before competing with other
similar business units. In this context, there is a need of intra-firm comparison.

8) Receivables Turnover Ratio

The accounts receivable turnover ratio is an accounting measure used to quantify a company's effectiveness in
collecting its receivables or money owed by clients. The ratio shows how well a company uses and manages the
credit it extends to customers and how quickly that short-term debt is collected or is paid. The receivables
turnover ratio is also called the accounts receivable turnover ratio

Calculate the Receivables Turnover Ratio

1. Add the value of accounts receivable at the beginning of the desired period to the value at the end of the
period and divide the sum by two. The result is the denominator in the formula.
2. Divide the value of net credit sales for the period by the average accounts receivable during the same
period.
3. Net credit sales are the revenue generated from sales that were done on credit minus any returns from
customers.

A High Accounts Receivable Turnover Ratio

A high receivables turnover ratio can indicate that a company’s collection of accounts receivable is efficient and
that the company has a high proportion of quality customers that pay their debts quickly. A high receivables
turnover ratio might also indicate that a company operates on a cash basis.A high ratio can also suggest that a
company is conservative when it comes to extending credit to its customers. A conservative credit policy can be
beneficial since it could help the company avoid extending credit to customers who may not be able to pay on
time.

A Low Accounts Receivable Turnover Ratio

A low receivables turnover ratio might be due to a company having a poor collection process, bad credit policies,
or customers that are not financially viable or creditworthy.Typically, a low turnover ratio implies that the company
should reassess its credit policies to ensure the timely collection of its receivables. However, if a company with a
low ratio improves its collection process, it might lead to an influx of cash from collecting on old credit or
receivables.

9 )Rate of Return
A rate of return (RoR) is the net gain or loss on an investment over a specified time period, expressed as a
percentage of the investment’s initial cost. Gains on investments are defined as income received plus any capital
gains realized on the sale of the investment. This simple rate of return is sometimes called the basic growth rate,
or alternatively, return on investment, or ROI. If you also consider the effect of the time value of money and
inflation, the real rate of return can also be defined as the net amount of discounted cash flows received on an
investment after adjusting for inflation.

A rate of return can be applied to any investment vehicle, from real estate to bonds, stocks and fine art, provided
the asset is purchased at one point in time and produces cash flow at some point in the future. Investments are
assessed based, in part, on past rates of return, which can be compared against assets of the same type to
determine which investments are the most attractive.

Use the Rate of Return

The rate of return can be calculated for any investment, dealing with any kind of asset. Let's take the example of
purchasing a home as a basic example for understanding how to calculate the RoR. Say that you buy a house for
Six years later, you decide to sell the house—maybe your family is growing and you need to move into a larger
place. You are able to sell the house for $335,000, after deducting any realtor's fees and
taxes. In finance, return is a profit on an investment.[1] It comprises any change in value of the investment,
and/or cash flows which the investor receives from the investment, such as interest payments or dividends. It
may be measured either in absolute terms (e.g., dollars) or as a percentage of the amount invested. The latter is
also called the holding period return.
A loss instead of a profit is described as a negative return, assuming the amount invested is greater than zero.

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The rate of return is a profit on an investment over a period of time, expressed as a proportion of the original
investment.[2] The time period is typically a year, in which case the rate of return is referred to as the annual
return.
10) Inter-Company Deposits
Meaning:
Inter-company deposit is the deposit made by a company that has surplus funds, to another company for a
maximum of 6 months. It is a source of short-term financing.
Features of Inter-corporate Deposits:
It is a popular source of short-term finance.
ii. Procurement procedure is simple.
iii. The rate of interest on such deposits is not fixed. It depends upon the amount involved and the tenure of
lending.
iv. It is uncertain source of finance, as deposit can be withdrawn any time—so it is risky also.
Advantages of Inter-company Deposits:

The advantages of inter-corporate deposits are:

i. Surplus funds can be effectively utilized by the lender company.
ii. Such deposits are secured in nature.
iii. Inter-corporate deposits can be easily procured.

Disadvantages of Inter-company Deposits:

Inter-company deposits suffer from following disadvantages:
i. A company cannot lend more than 10 per cent of its net worth to a single company and cannot lend beyond 30
per cent of its net worth in total.
ii. The market for such source of financing is not structured.

11) Leverage Ratio

A leverage ratio is any one of several financial measurements that look at how much capital comes in the form
of debt (loans) or assesses the ability of a company to meet its financial obligations. The leverage ratio category
is important because companies rely on a mixture of equity and debt to finance their operations, and knowing the
amount of debt held by a company is useful in evaluating whether it can pay its debts off as they come
due. Several common leverage ratios will be discussed below
Too much debt can be dangerous for a company and its investors. However, if a company's operations can
generate a higher rate of return than the interest rate on its loans, then the debt is helping to fuel growth in profits.
Nonetheless, uncontrolled debt levels can lead to credit downgrades or worse. On the other hand, too few debts
can also raise questions. A reluctance or inability to borrow may be a sign that operating margins are simply too
tight.

There are several different specific ratios that may be categorized as a leverage ratio, but the main factors
considered are debt, equity, assets, and interest expenses.

A leverage ratio may also be used to measure a company's mix of operating expenses to get an idea of how
changes in output will affect operating income. Fixed and variable costs are the two types of operating costs;
depending on the company and the industry, the mix will differ.

Finally, the consumer leverage ratio refers to the level of consumer debt as compared to disposable income and
is used in economic analysis and by policymakers.

Banks and Leverage Ratios

Banks are among the most leveraged institutions in the United States. The combination of fractional-reserve
banking and Federal Deposit Insurance Corporation (FDIC), protection has produced a banking environment with
limited lending risks.

To compensate for this, three separate regulatory bodies, the FDIC, the Federal Reserve and the Comptroller of
the Currency, review and restrict the leverage ratios for American banks. This means they restrict how much
money a bank can lend relative to how much capital the bank devotes to its own assets. The level of capital is
important because banks can "write down" the capital portion of their assets if total asset values drop. Assets
financed by debt cannot be written down because the bank's bondholders and depositors are owed those funds.

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12) Activity Ratios

Activity ratios are a category of financial ratios that measure a firm's ability to convert different accounts within its
balance sheets into cash or sales. Activity ratios measure the relative efficiency of a firm based on its use of its
assets, leverage, or other similar balance sheet items and are important in determining whether a company's
management is doing a good enough job of generating revenues and cash from its resources.

Companies typically try to turn their production into cash or sales as fast as possible because this will generally
lead to higher revenues, so analysts perform fundamental analysis by using common ratios such as the activity
ratio. Activity ratios measure the amount of resources invested in a company's collection and inventory
management. Because businesses typically operate using materials, inventory, and debt, activity ratios
determine how well an organization manages these areas.

Activity ratios gauge an organization's operational efficiency and profitability. These ratios are most useful when
compared to a competitor or industry to establish whether an entity's processes are favorable or unfavorable.
Activity ratios can form a basis of comparison across multiple reporting periods to determine changes over time.

Accounts Receivable Turnover Ratio

The accounts receivable turnover ratio determines an entity's ability to collect money from its customers. Total
credit sales are divided by the average accounts receivable balance for a specific period. This activity ratio
calculates management's ability to receive cash. A low ratio suggests a deficiency in the collection process.

Merchandise Inventory Turnover Ratio

The merchandise inventory turnover ratio measures how often the inventory balance is sold during an accounting
period. The cost of goods sold is divided by the average inventory for a specific period. Higher calculations
indicate inventory is quickly converted into sales and cash. A useful way to use this activity ratio is to compare it
to previous periods.

Total Assets Turnover Ratio

The total assets turnover ratio measures how efficiently an entity uses its assets to make a sale. Total sales are
divided by total assets to see how proficient a business is in using its assets. Smaller ratios may indicate that the
company is holding higher levels of inventory instead of selling.