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Financial Ratio Analysis: Intrduction
Financial Ratio Analysis: Intrduction
Intrduction
A firm communicates financial information to the users through statements and reports. The financial statements contain summarized information of the firms financial affairs, organized systematically. Preparation of financial statements is the responsibility of top management. As these statements are used by investors and financial analysts in order to examine the firms performance and make investment decisions, they should be prepared very carefully and contain as much as information as possible. Two basic financial statements prepared for the purpose of external reporting to owners, investors and creditors are (i) balance sheet (or statement of financial position) and (ii) profit and loss account (or income statement). For internal management purposes, i.e. planning and controlling, much more information than contained in the published financial statements is needed therefore, the financial accounting information is presented in different statements and reports in such a way as to serve the internal needs of managements, creditors, investors and others to form judgments about the operating performance and financial position of the position of the firm use the information contained in these statements. Users of financial statements can get better insight about the financial strengths and weakness of the firm if they properly analyse the information reported in these statements. Management is also interested in knowing the financial strengths and find out the weakness of the firm to take suitable actions at right time. The future plan of the firm is laid down in the view of the firms financial strengths and weakness. Thus financial analysis is the starting point for making plans, before making any sophisticated forecasting and planning procedures. Understanding the past is the prerequisite for anticipating the future. Financial ratio analysis is a study of ratios between various items or groups of items in financial statements. A ratio is an arithmetical relationship between two figures. Ratio analysis is a powerful tool of financial analysis. A ratio is defined as the indicated quotient of the two mathematical expression and as the relationship between two or more things. In financial analysis, a ratio is used as an index or yardstick for evaluating the financial position and performance of a firm. The absolute accounting figures reported in the financial statements do not provide a meaningful understanding of the performance and financial position of a firm. An accounting figure conveys meaning when it related to some other relevant information. For example, a Rs. 5 crore net profit may look impressive, but the firms performance can be said to be good or bad only when the net profit margin is related to the firm investment. The relationship between two accounting figure, expressed mathematically is known as a financial ratio (or simply as a ratio). Ratios help to summarise the large quantities of financial data and to make qualitative judgment about the firms financial performance. For example, consider current ratio (discussed later) it is calculated by dividing current assets by current liabilities; the ratios indicates a relationshipa quantified relationship between current asset and current liabilities; This relationship is an index or yardstick, which permits a qualitative judgment to be formed about the firms ability to meet its current obligation. It measures the firms liquidity. The greater the ratio, the greater the firm s liquidity and vive verse. The point to note is that a ratio indicates a quantitative relationship, which can be, in turn, used to make a qualitative judgment. Such is the nature of all financial ratios
Liquidity Ratios: Liquidity refers to the ability of a firm to meet its obligations in the short run, usually one year. The important liquidity ratios are: current ratio and acid-test ratio. Leverage Ratios: Leverage refers to the use of debt finance. While debt capital is cheaper source of finance, it is also risk source of finance. Leverage ratios help is assessing the risk arising from the use of debt capital. The commonly used leverage ratios are: debt-equity ratio, interest coverage ratio, and debt service coverage ratio. Turnover Ratios: Turnover ratios also referred to as activity ratios or asset management ratios, measure how efficiently the assets are employed by the firm. The important turnover ratios are: inventory turnover ratio, receivables turnover ratio, average collection period, fixed assets turnover ratio, and total assets turnover ratio. Profit margin Ratios: Profit margins reflect the relationship between profits (defined variously) and sales. The common used profit margin ratios are gross profit margin ratio, EBIT/Sales ratio, and net profit margin ratio. Return on Investment Ratios: Reflecting the relationship between profit and investment, return on investment ratios measure the overall financial performance of the firm. The most important return on investment ratios is: net income to total assets ratio, earning power, and return on equity. Valuation Ratios: Valuation Ratios indicate how the equity stock of the company is assed in the capital market. The commonly employed valuation ratios are: price earnings ratio, yield, and market price to book value ratio.
To facilitate this discussion, the financial statement of ABC Limited, shown in exhibits 2.2 and 2.3 shall be used.
Current ratio
Current Assets Current Liabilities Current assets include cash, marketable securities, debtors, inventories, loans and advances, and pre-paid expenses. Current liabilities consist of loans and advances (taken). Trade creditors, accrued expenses, and provisions. The current ratio, a very popular financial ratio, measures the ability of the firm to meet its current liabilities current assets get converted into cash in the operational cycle of the firm and provide the funds needed to the pay current liabilities. Apparently, the higher the current ratio, the greater the short term solvency
Quick assets Current Liabilities Quick assets are defined as current assets excluding inventories. The acid-test ratio, also called the quick ratio, is a fairly stringent measure of liquidity. It is a based on those current assets, which are highly liquid-inventories are excluded from the numerator of this ratio because inventories are deemed to be the least liquid component of current assets. Debt-Equity Ratio Debt Equity The numerator of this ratio consists of all liabilities, short-term as well as long-term, and the denominator consists of net worth plus preference capital. In general, the lower the debt-equity ratio, the higher the degree of protection enjoyed by the creditors. Interest Coverage Ratio Earnings before interest and taxes Debt Interest It may be noted that earnings before interest and taxes are used in the numerator of this ratio because the ability of a firm to pay interest is not affected by tax payment, as interest on debt funds is a tax-deductible expense. A high interest coverage ratio means that the firm can easily meet its interest burden even if earnings before interest and taxes suffer a considerable decline. A low interest coverage ratio may result in financial embarrassment when earnings before interest and taxes decline. A low interest coverage ratio may result in financial embarrassment when earnings before interest and taxes decline.
Inventory Turnover Ratio Net Sales Inventory The numerator of this ratio is the net sales for the year and the denominator is the inventory balance at the end of the year. The inventory turnover ratio is deemed to reflect the efficiency of inventory management. The higher the ratio, the more efficient the management of inventories and vice versa. However, this may not always be inventory, which may result in frequent stock outs and loss of sales and customer goodwill.
If the figure for credit sales is available, it is preferable to use it is in the numerator of this ratio. The receivables figure used in the denominator of this ratio is generally the receivables figure at the end of the period. However, when sales are highly seasonal or when sales growth is high, the year-end receivables figure is somewhat inappropriate. When sales are highly seasonal, the average of the receivables figures at the end of each month or each season may be used and when sales growth is high the average of the beginning and ending receivables balances may be used. The receivables turnover ratio and the average collection period related as follows:
Average collection period= 360 Receivables turnover ratio Obviously, the shorter the average collection period the higher the receivables turnover ratio and vice versa. The average collection period may be compared with the firms credit terms judge the efficiency of receivables management. Form example, if the credit terms are 2/10, net45, an average collection period of 85 days means that collection is slow and an average collection period of 40 days means that the collection is prompt. As a rule of thumb, the average collection period should not exceed One and times time the credit period. (This indeed is an arbitrary guide.) An average collection period, which is shorter than the credit period allowed by the firm, needs to be interpreted carefully. It may mean efficiency of credit management or excessive conservation in credit granting that may result in the loss of some desirables sales. Fixed Assets Turnover Ratio Net Sales Fixed assets The numerator of this ratio is the net sales for the period and the denominator is the balance in the net fixed assets account at the end of the year. This ratio is supposed to measure the efficiency with which fixed assets are employed - a high ratio indicates a high degree of efficiency in asset utilizations and a low ratio reflects inefficient use of assets. However, in interpreting this ratio, one caution should be borne in mind. When the fixed assets of the firm are old and substantially depreciated, the fixed assets turnover ratio tends to be high because the denominator of the ratio is very low. Total Assets Turnover Ratio Net Sales Total assets Total assets are simply the balance sheet at the end of the year. The ratio measures how efficiently assets are employed. Overall. It is all akin to the output capital ratio used in economic analysis.
Gross profit is defined as the difference between net sales and cost of goods sold. This ratio shows the margin left after meeting manufacturing costs. It measures the efficiency of production as well as pricing. To analyze the factors underlying the variation in gross profit margin, the proportion of various elements of cost (labour, materials and manufacturing overheads) to sales may be studied in detail.
Earning Power
Earnings before interest and taxes Total Assets The earning power is a measure of business performance, which is not affected by interest charges and tax payments. It abstracts away the effect of financial structure and tax rate and focuses on operating performance. Hence, it is eminently suited for inter-firm comparisons. Further, it is internally consistent. The numerator represents a measure of pre-tax earnings belonging to all resources of finance and the denominator represents total financing.
Return on Equity
Equity Earnings Net worth The numerator of this ratio is equal to profit after tax less preference dividends. The denominator includes all contribution made by equity shareholders (paid-up capital + reserves and surplus). This ratio is also called return on net worth.
The return on equity measures the profitability of equity funds invested in the firm. It is regarded as a very important measure because it reflects the productivity of the ownership (or risk) capital employed in the firm. It is influenced by several factors: earning power, debt-equity ratio, average cost of debt funds, and tax rate. In judging all the profitability measures it should be borne in mind that the historical valuation of assets imparts an upward bias to profitability measures during an inflationary period. This happens because the numerator of these measures represents current values, whereas the denominator represents historical values.
Yield
Dividend + Price Change Initial price This may be split into two parts: Dividend Initial price Dividend Yield + Price change Initial price Capital gains/loses yield
Generally, companies with low growth prospects offer high dividend yield and a low capital gains yield. On the other hand, companies with superior growth prospects offer a low dividend yield and a high capital gains yield.
Liquidity Ratios
1
Current Ratio
Current Ratio Current Liabilities Current assets- Inventory Current Liabilities Current assets- Inventory Average daily cash operating expenses
Quick Ratio
Interval Ratio
Leverage Ratios
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Total Debt Capital Employed Net worth Total Debt Capital employed or net assets Net worth EBIT + Depreciation Interest
Activity Ratios
Inventory turnover No. of days, Inventory Debtors turnover Collection period turnover
Cost of goods sold or sales Inventory 360 Inventory turnover Creditors sales or sales Debtors 360 Debtors turnover Sales Net assets or capital employed Sales Net working capital
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11
12 Assets
13
Profitability Ratios
14
Gross Margin
Gross profit Sales Profit after tax/EBIT Sales EBIT PAT EBIT or (1-Tax rate) Net assets or Capital employed Profit after a Tax Net worth PAT No of Shares Profit distributed No of Shares DPS EPS Market price of share EPS Market price of the ratio Book value of the share
15
16
17
18
19
EPS
20
DPS
21
22
23
24
Yield
Investors
to help them determine whether they should buy shares in the business, hold on to the shares they already own or sell the shares they already own. They also want to assess the ability of the business to pay dividends. to determine whether their loans and interest will be paid when due might need segmental and total information to see how they fit into the overall picture information about the stability and profitability of their employers to assess the ability of the business to provide remuneration, retirement benefits and employment opportunities businesses supplying goods and materials to other businesses will read their accounts to see that they don't have problems: after all, any supplier wants to know if his customers are going to pay their bills! the continuance of a business, especially when they have a long term involvement with, or are dependent on, the business the allocation of resources and, therefore, the activities of business. To regulate the activities of business, determine taxation policies and as the basis for national income and similar statistics information about the trends and recent developments in the prosperity of the business and the range of its activities as they affect their area They need to know, for example, the accounting concepts employed for inventories, depreciation, bad debts and so on Many organizations now publish reports specifically aimed at informing us about how they are working to keep their environment clean.
Suppliers and other trade creditors Customers Governments and their agencies
Researchers
Researchers demands cover a very wide range of lines of enquiry ranging from detailed statistical analysis of the income statement and balance sheet data extending over many years to the qualitative analysis of the wording of the statements
Interest Group
Investors Lenders Managers Employees Suppliers and other trade creditors Customers Governments and their agencies Local Community Financial analysts Environmental groups Researchers
Ratios to watch
Return on Capital Employed Gearing ratios Profitability ratios Return on Capital Employed Liquidity Profitability Profitability This could be a long and interesting list Possibly all ratios Expenditure on anti-pollution measures Depends on the nature of their study
Utility of Ratio Analysis The ratio analysis is the most powerful tool of the financial analysis. With the help of ratios, we can determine: 1. Examining trends in results over a number of years. 2. Comparing the results of a business with results of other businesses.
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3. Comparing the results of the business with the average results of all businesses in that sector. 4. Ability of the firm to meet its current obligation. As stated previously, a short-term creditor will be interested in current financial position of the firm, while a long-term creditor will pay more attention to solvency of the firm. The long-term creditor will also be interested in the profitability of the firm. The equity shareholders are generally concerned with their return and may bother about firms financial condition only when their earnings are depressed. The ratio analysis is also useful in security analysis. The major focus in security analysis is on the long-term profitability. Profitability is dependent on a number of factors and, therefore, the security analyst also analyses other ratios. Management has to protect the interest of all concerned parties, creditors, owners and others. They have to ensure some minimum operating efficiency and keep the risk of the firm at a minimum level. Their survival depends upon their operating performance. From time to time, management uses ratio analysis to determine the firms financial strengths and weakness, and accordingly takes actions to improve the firms position. Management is in a better position to analyse the firms financial position as it has access to internal information, which is not available to the credit analyst or the security analyst. Diagnostic role of Ratios The essence of the financial soundness of a company lies in balancing its goals, commercial strategy, product-marketing choices and resultant financial needs. The company should have financial capability and flexibility to pursue its commercial strategy. Ratio analysis is a very useful analytical technique to raise pertinent questions on a number of managerial issues. It provides bases or clues to investigate such issues in detail. While assessing the financial health of the company with the help of ratio analysis, answers to the following questions may be sought: 1. How profitable is the company? What accounting polices and practices are followed by the company? Are they stable? 2. Is the profitability (RONA) of the company high/low/average? Is it due to: a. Profit margin b. Asset utilization c. Non-operating income d. Window dressing e. Change in accounting policy f. Inflationary condition? 3. Is the return on equity (ROE) high/low/average? Is it due to: a. Return on investment b. Financing mix c. Capitalization of reserves? 4. What is the trend in profitability? Is it improving because of better utilization of resources or curtailment of expenses of strategic importance? What is the impact of cyclical factors on profitability trends? 5. Can the company sustain its impressive profitability or improve its profitability given the competitive and other environment situation? 6. How effectively does company utilize its assets in generating sales?
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