Financial Ratio Analysis

Introduction

Financial ratio analysis is a concept of finance in which the financial performance of a company is identified by comparing various entries in the balance sheet and trading profit and loss account of the company. It is an important tool of analysis used by various stakeholders of a company to determine the financial performance of the company so that they can make appropriate decisions regarding their engagement with the company.

Financial ratios are used to measure the financial health of an organisation in the past and the future (Dyson, 2010). A ratio is obtained from dividing one arithmetic amount from another arithmetic amount and expressing it as a percentage or as a factor. Ratio analysis therefore compares different figures.

There are many ratios that can be derived from a company’s balance sheet and trading profit and loss account. However, a few categories are provided in this article. They include: liquidity ratios, profitability ratios, efficiency ratios and investment ratios. These categories have other smaller types of ratios which differ in terms of accounting figures used but are used to analyse the same line of financial performance.

The Four Categories of Financial Ratios

1) Liquidity ratios

Liquidity ratios are also known as working capital ratios. They show the ability of a company to meet its short term financial obligations as they fall due or how quickly assets can be turned into cash in order to pay off short term liabilities (Sutton, 2004). The two liquidity ratios are current assets ratio and acid test ratio.

Current Assets Ratio

The current asset ratio measures the number of times that a company can pay its current liabilities using current assets before the current assets are exhausted. The current assets ratio is given by the formula, current assets/current liabilities. If the current ratio is 2:1, then it means that the current assets are twice the current liabilities. This is the recommended size of the current assets ratio because it means there are enough current assets to pay current liabilities.

Acid Test Ratio

The formula of acid test ratio is; (current assets – Stock)/current liabilities. It shows the ability of the firm to pay its current liabilities using more liquid assets (excluding stock and prepayments). For example, if the total current assets = $200; stock = $20 and total current liabilities = $90; then the acid test ratio = (200-20)/90 = 2.0. This shows that for every single unit of liabilities, there are two units of more liquid assets.

2) Profitability Ratios

This category of ratios measures the amount of profits made by a business. Two of the profitability ratios are: net profit margin and Return on capital employed ROCE).

Net Profit Margin Ratio

Net profit margin measures profitability in relation to sales, and can be given by the formula: (net profit before taxation/sales) × 100. This measures the ability of the firm to control its financial expenses (Ryan, 2004). For example, if a company records a net profit of $2.4 billion and its sales for the year were $10.6 billion, then the net profit will be given as (2.4/10.6) × 100 = 22.64%. This means that 22.64% of the sales remained as net profits while the other 77.36% were eaten up by cost of sales, operating expenses and financing expenses.

Return on Capital Employed

The return on capital employed measures profitability of the firm in terms of investment, and can be calculated as: (Net Profit × 100)/capital employed. This ratio measures the amount of profits that can be generated by a single unit of capital employed. For instance, if the net profit made is $2.4 billion while the capital employed (in terms of shareholder’s equity) is $7.2 billion, then the ROCE will be given as (2.4 × 100)/7.2 = 33.33%. This indicates that a single unit of capital employed generates 0.3333 units of profits.

3) Efficiency ratios

Efficiency ratios measure how efficient the firm is when utilizing its assets or resources to generate revenue (Dyson, 2010). The two types of efficiency ratios are: stock turnover ratio and trade debtor collection period.

Stock Turnover Ratio

The stock turnover ratio is calculated as follows: cost of goods sold/closing stock. This is usually expressed as a number. This ratio shows the number of times that stock has been turned into sales in a company within a given financial year. For example, if the cost of goods sold in a company is $1.2 billion while the closing stock is $0.5 billion then the stock turnover ratio will be: 1.2/0.5 = 2.4. This means that stock was turned into sales 2.4 times in the company.

Trade Debtor Collection Period

The trade debtor collection period is calculated using the formula: (closing trade debtors × 365)/credit sales. This refers to the period within which trade debtors are required to pay their dues to the company. For example if a company records closing trade debtors of $0.7 billion and its credit sales are $10.6 billion then the trade debtors collection period is (0.7 × 365)/10.6 = 24.3. This means that debtors take 24 days to pay what they owe the company.

4) Investment ratios

These are ratios that are exclusively of interest to investors; they determine the value of the firm and the performance of investments made by various investors in the firm. It also measures the growth potential of the firm. Investment ratios include dividend yield ratio and price to earnings ratio.

Dividend Yield Ratio

The formula for dividend yield ratio is (dividend per share/market price per share) × 100. This ratio measures the dividend returns of shareholders for every unit of investment in the company (Dyson, 2010). For example, if an investor invests in a company with shares which yield $0.22 per share and the market price of the company’s shares is $4.34, then the dividend yield will be 0.22/4.34 = 5.06%. This means that a single unit of investment in the company yields 0.05 units of return.

Price Earnings Ratio

Price to earnings ratio (P/E) is given as: market price per share/earnings per share. This indicates the payback period for the market price per share (MPS). That is, it measures the number of years it takes to recover the MPS from the annual earnings per share of the company. If the market price per share is 4.34 and the earnings per share is $0.12, then the P/E = 4.34/0.12 = 36.17. This indicates that it takes 36 years to recover the market earnings per share from the annual earnings per share of the company.

Usefulness of Financial ratios

Financial ratios can be used in many ways.

First, it is used to generate sales revenue. In this case, turnover ratios will indicate the amount of assets needed to be invested in order to generate sales revenue.

The ratios are also used by various stakeholders including creditors to measure the ability of the firm to meet its financial obligations (Ryan, 2004). This enables creditors to make decisions on whether to provide credit to the firm or not.

Furthermore, financial ratios are used to carry out industrial analysis. In this case, the performance of a firm is compared to the performance of other competing firms in the industry.

They are also used to carry out trend or time series analysis whereby the performance of the firm is evaluated over time (Harrison and Horngren, 2001). This enables users of financial information to determine the future financial viability of the company based on its historical performance.

Financial ratios, e.g. gearing ratios can also be used to determine the bankruptcy or leverage value of the firm. This helps investors to determine whether a firm is financially viable for investment.

Limitations

One of the limitations of financial ratios is that it ignores the size of the company being analysed. For example, the size of the firm against competitors in the industry might be different; so financial performance ought to be different.

Ratios also ignore the impact of inflation when used in making time series of trend analysis. Increase in sales this year might be due to general rise in prices due to inflation.

Ratios also don’t take into consideration the qualitative and quantitative elements of the firm including reputation, management team, customer loyalty, and product quality (Sutton, 2004). Since financial ratios are calculated only at one point in time, they are usually subject to changes after computation.

Lastly, financial ratios are calculated based on historical data which may be irrelevant for future decision making due to changes in the economy and market conditions.

Summary

It is clear that there are various financial ratios which are used to measure the performance of companies.

  • Liquidity ratios show the ability of a company to meet its short term financial obligations as they fall due; and they include current ratio and acid test ratio.
  • Efficiency ratios show how efficient the firm is when utilizing its assets or resources to generate revenue; they include stock turnover ratio and trade debtor collection period.
  • Profitability ratios measure the amount of profits made by a business and investment ratios determine the value of the firm and the performance of investments made by various investors in the firm.

These ratios have usefulness and limitations.

  • In terms if usefulness, various stakeholders use them to evaluate the performance of the company and make relevant decision making regarding their engagements with the company.
  • In terms of limitations, ratios are based on historical values, ignore inflation, ignore qualitative and quantitative aspects of the firm, and ignore the size of the firm being analysed or evaluated for decision making.

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