Saturday, March 31, 2012

Financial Ratios

 Financial ratios are important pointers to the performance of a company. Looking at a combination of these ration a lot of conclusion can be drawn about the company's performance and operations. The important financial ratios are as follows

Important Terms:
  1. Shareholders Equity: At any given point the equity is the total assets - total liabilities.  
  2. Operating Income: it is the income or profit generated by the operations and is calculated as total sales - COGS - operating expenses - depreciation. It is also known as EBIT earnings before interest and taxes.

Debit/Equity: This ratio is calculated as
                 Total Liabilities
             Shareholders Equity
 a debt to equity ratio of 5 would mean that for every 1 dollar of equity there is a 5 dollar liability. Any company with a high Debt to equity would have low investor interest.

Equity Ratio: This ratio is similar to the above debt to equity ratio, however the focus here is on assets instead of the liabilities. It is used in central europe and is calculated as follows:
                     Total Equity
                      Total Assets
This ratio helps to detemine how much the shareholders would receive in an event of a company wide liquidation. This ratio is expressed as a percentage of the total assets. Thus an equity ratio of 45% for a company with total assets of 500 $ million would mean that in an event of liquidation all the shareholders put togeather would receive $225 million (45% * $500).

Return on Equity : This ratio is expressed as a percentage and is calculated as
                           Net Income
                  Shareholder's Equity
This ratio is a measure of how efficient a company is at generating profits. A company with higher ROE took lesser investment and generated higher profits and hence would be of interest to investors.

Operating Profit Margin: This ratio is expressed as a percentage and is calculated as
                      Operating Income
                         Total Revenue
This ratio is a measure of how much the company makes on each dollar of sales before interest and taxes. This ratio displays how efficient a companys operations are at making profits. An operating profit margin of 12% would mean that it the operations make $0.12 (before interest and taxes) for every dollar of sales.

Thursday, March 08, 2012

Costing Methods

Standard Cost

When to use standard costing to value the inventory depends on two issues. 

Firstly, if you in the business of make to stock manufacturing, making the same things in the same way over and over. Make to stock environments make sense for standards since most things are made over and over again, and are supposed to use the same effort, and have the same input costs. If they don't, management should know about it promptly to get things back on track. That's the role of standard cost variance reporting.

Secondly, do you have the resources on staff that can manage standard costs in a timely manner, before any transactions happen? In early days with the missing sofistication of the business systems Standard costing was an easy substitute for the vast amount of data accumulation required to aggregate actual cost information. Also in business scenarios where there is a possibility of negative stock there might be challenges to cost these negative transactions where standard cost works well.


The average costing method is the preferred method of costing for distribution and other industries where the product cost fluctuates rapidly. The fluctation in the reported profits (monthly/ yearly) are reduced when using this method as the increase in the cost would be lesser when compared to the increase in the average cost.


It is very common to use the FIFO method if one trades in foodstuffs and other goods that have a limited shelf life, because the oldest goods need to be sold before they pass their sell-by date.


In the LIFO method the last inventory cost is consumed first so in most cases this increases the COGS and hence reduces the margins that are reporting in the P&L, because the cost of goods generally goes up over time; which also reduces the income tax liabilities of the company this method however is used in US but due to the above mentioned flaw is disallowed in non-US countries.