Literature Review

A financial ratio is a number that expresses the value of one financial variable relative to another. It is the numeric result gained by dividing one financial number by another. Calculated this way, financial ratio allows an analyst to assess not only the - 3 -absolute value of a relationship but also to quantify the degree of change within t he relationship (Lawder, 1989). From a management perspective, the rationale for use of financial ratio analysis is that by expressing several figures as rat io, information will be revealed that is missed when the individual members are observed (Thomas & Evanson, 1987). Managers can then use this information to improve their operations. Users of such financial data and ratios may include companies evaluating the creditworthiness of their debtors, investors considering the merit of alternative investment, a nd banks and other lenders when granting loans. Also, auditors can use ratios when conducting analytical reviews of their clients (Gardiner, 1995) Ratios are a valuable analytical tool when used as part of a thorough financial analysis. They can show the standing of a particular company, within a particular industry. However, ratios alone can sometimes be misleading. Ratios are just one piece of the financial jigsaw puzzle that makes up a complete analysis. (Leslie Rogers, 1997) Financial ratios are widely used to develop insights into the financial performance of companies¶ by both the evaluators¶ and researchers¶. The firm involves many interested parties, like the owners, management, personnel, customers, suppliers, competitors, regulatory agencies, and a cademics, each having their views in applying financial statement analysis in their evaluations. Evaluators¶ use financial ratios, for instance, to forecast the future success of companies, while the researche rs' main interest has been to develop models ex ploiting these ratios. (Salmi, Vitanen, and Olli, 1990) In trend analysis, ratios are compared over time, typically years. Year -to-year comparisons can highlight trends and point up the need for action. Trend analysis works best with three to five years of ratios. The second type of ratio analysis, cross -sectional analysis, compares the ratios of two or more companies in similar lines of business. One of the most popular forms of cross -sectional analysis compares a company's ratios to industry averages. The se averages are developed by statistical services and trade associations and are updated annually. (Ezzamel, Mar -Molinero and Beecher, 1987) Financial ratios can also give mixed signals about a company's financial health, and can vary significantly among c ompanies, industries, and over time. Other factors should also be considered such as a company's products, management, competitors, and vision for the future. (Fieldsend, Longford and McLeay, 1987) There are many different ratios and models used today to analyze companies. The most common is the price earnings (P/E) ratio. It is published daily with the transactions of the New York Stock Exchange, American Stock Exchange, and NASDAQ. These quotations show not only the most recent price but also the highest and lowest price paid for the stock during the previous fifty -two weeks, the annual dividend, the dividend yield, the price/earnings ratio, the day's trading volume, high and low prices for the day, the changes from the previous day 's closing price. The price to earnings (P/E) ratio is calculated by dividing the current market price per share by current earnings per share. It represents a multiplier applied to current earnings to determine the value of a share of the stock in the market. The price-earnings ratio is influenced by the earnings and sales growth of the company, the risk (or volatility in performance), the debtequity structure of the company, the dividend policy, the quality of management, and a number of other factors. A company's P/E ratio shou ld be compared to those of other companies in the same industry. (Garcia -Ayuso, 1994) In very general terms three categories of financial ratios are more or less common: profitability, long -term solvency (capital structure) and short-term solvency (liquidity). (Courtis, 1978) Financial ratios can be divided for convenience into four basic groups or categories: liquidity ratios, activity ratios, debt ratios, and profitability ratios. Liquidity, activity, and debt ratios primarily measure risk; profitability ratios measure return. (Owens and Epstein, 1995) The following is a listing of some of the ratios to be aware of in analyzing a company's balance sheet and income statement. These ratios fall into four categories ² liquidity, profitability, asset managemen t (efficiency), and debt management (leverage). (Perttunen and Martikainen, 1990) When a firm borrows money, it promises to make a series of interest payments and then to repay the amount that it has borrowed. If profits rise, the debt holders continue to receive a fixed interest payment, so that all the gains go to the shareholders. Of course, the reverse happens if profits fal l. In this case shareholders bear all the pain. If times are sufficiently hard, a firm that has borrowed heavily may not be able to pay its debts. The firm is then bankrupt and shareholders lose their entire investment. Because debt increases returns to shareholders in good times and reduces them in bad times, it is said to create financial leverage. Leverage ratios measure how much financial leverage the firm has taken on. (Brealey, Myers, and Marcus, 2001) If you are extending credit to a customer or making a short -term bank loan, you are interested in more than the company¶s leverage. You want to know whether it will be able to lay its hands on the cash to repay you. That is why credit analysts and bankers look at several measures of liquidity. Liquid assets can be converted into cash quickly and cheaply. (McLeay and Fieldsend, 1987) Once you have selected and calculated the importan t ratios, you still need some way of judging whether they are high or low. A good starting point is to compare them with the equivalent figures for the same company in earlier years. Also known as benchmarking or cross-sectional analysis in which the firm¶ s ratio values are compared to those of a key competitor or a group of competitors, primarily to isolate areas of opportunity for improvement. (Gitman, 1997) Following are the cautions while doing financial analysis. First, a single ratio does not generall y provide sufficient information from which to judge the overall performance and status of the firm. Only when a group of ratios is used can reasonable judgments be made. If an analysis is concerned only with certain specific aspects of a firm¶s financial position, one or two ratios may be sufficient. Second, It is preferable to use audited financial statements for ratio analysis. If the statements have not been audited, the re may be no reason to believe that the data contained in them reflect the firm¶s tr ue financial condition. Third, the financial

1997) Income statement measures a company¶s financial performance between balance sheet dates and hence. Creditors are bankers. (Bernstein and Wild. Time -series analysis is often helpful in checking the reasonableness of a firm¶s projected financial statements. Most companies are required under accepted accounting practices to present a classified balance sheet. and operating activities. Creditors look to financial statements for evidence concerning the ability of the borrower to pay periodic interests payments and repay the principal amount when the loan matures. Equity investors are generally interested in assessing the future profitability or riskiness of a company. 2001) Financial statement analysis applies analytical tools and techniques to general purpose financial statements and relates data to derive estimates and inferences useful in business decisions. allows the firm to determine whether it is progressing as planned. and in turn it diminishes our uncertainty in decisionmaking. bondholder s. investing. Frequently. External users are individual s not directly involved in the company¶s operations. It lists revenues. 1995) Financial statement users are broadly classified into two groups. guesses. A comparison of current and past ratios to those resulting from an analysis of projected statements may reveal discrepancies. It is a diagnostic tool in assessing financing.data being compared should have been developed in the same way. and total assets divide all balance sheet items. and customers. Thus. 1997) It is impo rtant to analyze trends in ratios as well as their absolute levels. (Whitis and Keith. and other individuals who lend money to business enterprises. expenses. and is a forecasting tool of future financial conditions and consequences. 1990) . Using multiyear comparisons can see developing trends. and knowledge of these trends should assist the firm in planning future operations. in their role as appo intees of shareholders. a common size income statement shows each item as a percentage of sales. are involved in making operating and strategic decisions for the business. (Judy Ward. It does not lessen the need for expert judgment but rather establishes an effective and systematic basis for making business decisions. Common size analysis is also useful in comparative analysis. It is a screening tool in selecting investment or merger candidates. suppliers. and intuition. (Bernstein and Wild. Auditors use financial analysis techniques in determining areas warranting special attention during their examination of a client¶s financial statements. they typically have com plete access to a company¶s information system. including the Securities and Exchange Commission. for trends give clues as to whether a firm¶s financial condition i s likely to improve or to deteriorate. primarily the managers of a company. intermediaries. which watchfully oversees published financial statemen ts for compliance with federal rites law. Common size analysis and percent change analysis are two other techniques that can be used to identify trends in financial statements. The use of differing accounting treatments. Current liabilities are obligations that the company must settle in the same time peri od. (Gitman. or internal auditor. Comparison of current to past performance. reflects a period of time. gains. Equity investors include existing and potential shareholders of a company. 1993) Tim e-series analysis is applied when a financial analysts evaluates performance over time. (Brigham and Ehrhardt. A company¶s board of directors. The typical business is interested in how well it has performed in relation to other firms in the industry. Regulatory agencies utilize financial statements in the exercise of their supervisory functions. (Gitman. (Brigham and Ehrhardt. CFO. monitors management¶s actions. which ever is longer. all income statement items are divided by sales. especially relative to inventory and depreciation can distort the results. These users must rely on information provided by management as part of the financial reporting process. In a common size analysis. using ratio analysis. The difference between current assets and current liabilities is working capital. Financial statement analysis reduces our reliance on hunches. Internally generated financial reports are. therefore. Net income. 1990) A balance sheet summarizes the financial po sition of a company at a given point in time. As in cross -sectional analysis. Currents assets are expected to be converted to cash and used in operations within one year or the operating cycle. and losses of a company over a time period. and is an evaluation tool for managerial and other business decisions. As employees. Potential shareholders need financial information to help in choosing among competing alternative investments. a firm will compare its ra tio values to those of a key competitor or group of competitors that it wishes to f ollow. In which assets and liabilities are separated into curre nt and non-current accounts. and a common a common size balance sheet shows each item as a percentage of total assets. Merger and acquisition analysts are interested in determining the economic value and assessing the financial and operati ng compatibility of potential merger candidates. Internal users. shows the increase (or decrease) in net worth of a company before considering distributions to and contributions from shareholders. There are many classes of external users of financial statements. Other users include employees. specifically tailored to the unique information ne eds of an internal decision maker. such as CEO. 2001) Cross sectional analysis involves the comparison of different firms¶ financial ratios at the sane point in time. Exiting shareholders need financial information in deciding whether to continue holding the stock or sell it. any significant year-to-year changes can be evaluated to access whether they are symptomatic of a major problem.

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