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What Is Ratio Analysis?
- What Does It Tell You?
- Application
- Ratio Analysis FAQs
The Bottom Line
Financial Ratios
Financial Ratio Analysis: Definition, Types, Examples, and How to Use
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Ratio analysis is a quantitative method of gaining insight into a company's liquidity, operational efficiency, and profitability by studying its financial statements such as the balance sheet and income statement. Ratio analysis is a cornerstone of fundamental equity analysis .
Key Takeaways
- Ratio analysis compares line-item data from a company's financial statements to reveal insights regarding profitability, liquidity, operational efficiency, and solvency.
- Ratio analysis can mark how a company is performing over time, while comparing a company to another within the same industry or sector.
- Ratio analysis may also be required by external parties that set benchmarks often tied to risk.
- While ratios offer useful insight into a company, they should be paired with other metrics, to obtain a broader picture of a company's financial health.
- Examples of ratio analysis include current ratio, gross profit margin ratio, inventory turnover ratio.
Ratio Analysis
What does ratio analysis tell you.
Investors and analysts employ ratio analysis to evaluate the financial health of companies by scrutinizing past and current financial statements. Comparative data can demonstrate how a company is performing over time and can be used to estimate likely future performance. This data can also compare a company's financial standing with industry averages while measuring how a company stacks up against others within the same sector.
Investors can use ratio analysis easily, and every figure needed to calculate the ratios is found on a company's financial statements.
Ratios are comparison points for companies. They evaluate stocks within an industry. Likewise, they measure a company today against its historical numbers. In most cases, it is also important to understand the variables driving ratios as management has the flexibility to, at times, alter its strategy to make its stock and company ratios more attractive. Generally, ratios are typically not used in isolation but rather in combination with other ratios. Having a good idea of the ratios in each of the four previously mentioned categories will give you a comprehensive view of the company from different angles and help you spot potential red flags.
A ratio is the relation between two amounts showing the number of times one value contains or is contained within the other.
Types of Ratio Analysis
The various kinds of financial ratios available may be broadly grouped into the following six silos, based on the sets of data they provide:
1. Liquidity Ratios
Liquidity ratios measure a company's ability to pay off its short-term debts as they become due, using the company's current or quick assets. Liquidity ratios include the current ratio, quick ratio, and working capital ratio.
2. Solvency Ratios
Also called financial leverage ratios, solvency ratios compare a company's debt levels with its assets, equity, and earnings, to evaluate the likelihood of a company staying afloat over the long haul, by paying off its long-term debt as well as the interest on its debt. Examples of solvency ratios include: debt-equity ratios, debt-assets ratios, and interest coverage ratios.
3. Profitability Ratios
These ratios convey how well a company can generate profits from its operations. Profit margin, return on assets, return on equity, return on capital employed, and gross margin ratios are all examples of profitability ratios .
4. Efficiency Ratios
Also called activity ratios, efficiency ratios evaluate how efficiently a company uses its assets and liabilities to generate sales and maximize profits. Key efficiency ratios include: turnover ratio, inventory turnover, and days' sales in inventory.
5. Coverage Ratios
Coverage ratios measure a company's ability to make the interest payments and other obligations associated with its debts. Examples include the times interest earned ratio and the debt-service coverage ratio .
6. Market Prospect Ratios
These are the most commonly used ratios in fundamental analysis. They include dividend yield , P/E ratio , earnings per share (EPS), and dividend payout ratio . Investors use these metrics to predict earnings and future performance.
For example, if the average P/E ratio of all companies in the S&P 500 index is 20, and the majority of companies have P/Es between 15 and 25, a stock with a P/E ratio of seven would be considered undervalued. In contrast, one with a P/E ratio of 50 would be considered overvalued. The former may trend upwards in the future, while the latter may trend downwards until each aligns with its intrinsic value.
Most ratio analysis is only used for internal decision making. Though some benchmarks are set externally (discussed below), ratio analysis is often not a required aspect of budgeting or planning.
Application of Ratio Analysis
The fundamental basis of ratio analysis is to compare multiple figures and derive a calculated value. By itself, that value may hold little to no value. Instead, ratio analysis must often be applied to a comparable to determine whether or a company's financial health is strong, weak, improving, or deteriorating.
Ratio Analysis Over Time
A company can perform ratio analysis over time to get a better understanding of the trajectory of its company. Instead of being focused on where it is today, the company is more interested doing this type of analysis is more interested in how the company has performed over time, what changes have worked, and what risks still exist looking to the future. Performing ratio analysis is a central part in forming long-term decisions and strategic planning .
To perform ratio analysis over time, a company selects a single financial ratio, then calculates that ratio on a fixed cadence (i.e. calculating its quick ratio every month). Be mindful of seasonality and how temporarily fluctuations in account balances may impact month-over-month ratio calculations. Then, a company analyzes how the ratio has changed over time (whether it is improving, the rate at which it is changing, and whether the company wanted the ratio to change over time).
Ratio Analysis Across Companies
Imagine a company with a 10% gross profit margin. A company may be thrilled with this financial ratio until it learns that every competitor is achieving a gross profit margin of 25%. Ratio analysis is incredibly useful for a company to better stand how its performance compares to similar companies.
To correctly implement ratio analysis to compare different companies, consider only analyzing similar companies within the same industry . In addition, be mindful how different capital structures and company sizes may impact a company's ability to be efficient. In addition, consider how companies with varying product lines (i.e. some technology companies may offer products as well as services, two different product lines with varying impacts to ratio analysis).
Different industries simply have different ratio expectations. A debt-equity ratio that might be normal for a utility company that can obtain low-cost debt might be deemed unsustainably high for a technology company that relies heavier on private investor funding.
Ratio Analysis Against Benchmarks
Companies may set internal targets for what they want their ratio analysis calculations to be equal to. These calculations may hold current levels steady or strive for operational growth. For example, a company's existing current ratio may be 1.1; if the company wants to become more liquid, it may set the internal target of having a current ratio of 1.2 by the end of the fiscal year.
Benchmarks are also frequently implemented by external parties such lenders. Lending institutions often set requirements for financial health. If these benchmarks are not met, an entire loan may be callable or a company may be faced with an adjusted higher rate of interest to compensation for this risk. An example of a benchmark set by a lender is often the debt service coverage ratio which measures a company's cash flow against it's debt balances.
Examples of Ratio Analysis in Use
Ratio analysis can predict a company's future performance — for better or worse. Successful companies generally boast solid ratios in all areas, where any sudden hint of weakness in one area may spark a significant stock sell-off. Let's look at a few simple examples
Net profit margin , often referred to simply as profit margin or the bottom line, is a ratio that investors use to compare the profitability of companies within the same sector. It's calculated by dividing a company's net income by its revenues. Instead of dissecting financial statements to compare how profitable companies are, an investor can use this ratio instead. For example, suppose company ABC and company DEF are in the same sector with profit margins of 50% and 10%, respectively. An investor can easily compare the two companies and conclude that ABC converted 50% of its revenues into profits, while DEF only converted 10%.
Using the companies from the above example, suppose ABC has a P/E ratio of 100, while DEF has a P/E ratio of 10. An average investor concludes that investors are willing to pay $100 per $1 of earnings ABC generates and only $10 per $1 of earnings DEF generates.
What Are the Types of Ratio Analysis?
Financial ratio analysis is often broken into five different types: profitability, solvency, liquidity, turnover, and earnings ratios. Other non-financial metrics may be scattered across various departments and industries. For example, a marketing department may use a conversion click ratio to analyze customer capture.
What Are the Uses of Ratio Analysis?
Ratio analysis serves three main uses. First, ratio analysis can be performed to track changes to a company over time to better understand the trajectory of operations. Second, ratio analysis can be performed to compare results with other similar companies to see how the company is doing compared to competitors. Third, ratio analysis can be performed to strive for specific internally-set or externally-set benchmarks.
Why Is Ratio Analysis Important?
Ratio analysis is important because it may portray a more accurate representation of the state of operations for a company. Consider a company that made $1 billion of revenue last quarter. Though this seems ideal, the company might have had a negative gross profit margin, a decrease in liquidity ratio metrics, and lower earnings compared to equity than in prior periods. Static numbers on their own may not fully explain how a company is performing.
What Is an Example of Ratio Analysis?
Consider the inventory turnover ratio that measures how quickly a company converts inventory to a sale. A company can track its inventory turnover over a full calendar year to see how quickly it converted goods to cash each month. Then, a company can explore the reasons certain months lagged or why certain months exceeded expectations.
There is often an overwhelming amount of data and information useful for a company to make decisions. To make better use of their information, a company may compare several numbers together. This process called ratio analysis allows a company to gain better insights to how it is performing over time, against competition, and against internal goals. Ratio analysis is usually rooted heavily with financial metrics, though ratio analysis can be performed with non-financial data.
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An Assignment on “Ratio Analysis”
A sustainable business and mission requires effective planning and financial management. Ratio analysis is a useful management tool that will improve your understanding of financial results and trends over time, and provide key indicators of organizational performance. Managers will use ratio analysis to pinpoint strengths and weaknesses from which strategies and initiatives can be formed. Funders may use ratio analysis to measure your results against other organizations or make judgments concerning management effectiveness and mission impact. For ratios to be useful and meaningful, they must be: • Calculated using reliable, accurate financial information (does your financial information reflect your true cost picture?) • Calculated consistently from period to period. • Used in comparison to internal benchmarks and goals o Used in comparison to other companies in your industry. • Viewed both at a single point in time and as an indication of broad trends and issues over time. • Carefully interpreted in the proper context, considering there are many other important factors and indicators involved in assessing performance. Ratios can be divided into four major categories: • Profitability Sustainability • Operational Efficiency • Liquidity • Leverage (Funding – Debt, Equity, Grants) The ratios presented below represent some of the standard ratios used in business practice and are provided as guidelines. Not all these ratios will provide the information you need to support your particular decisions and strategies. You can also develop your own ratios and indicators based on what you consider important and meaningful to your organization and stakeholders.
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ACCOUNTING RATIO ANALYSIS TO ASSESS THE ACCOUNTING SECTOR IN GALADARI HOTELS (LANKA) PLC. – FINANCIAL YEAR 2009/2010 –
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- 1. ACCOUNTING RATIO ANALYSIS TO ASSESS THE ACCOUNTING SECTOR IN GALADARI HOTELS (LANKA) PLC. – FINANCIAL YEAR 2009/2010 – Accounting and Finance - Pgdbm 503 Assignment 1 Mohammed Muthalif Fathima Nasriya Registration No. 072 Postgraduate Diploma in Business Management Faculty of Graduate Studies University of Colombo Sri Lanka February 2014
- 2. 1. INTRODUCTION Business has never been as competitive as it stands today, there are witnessed the fall of many industry giants within the last decade than ever before. Industry experts and scholars put this down to many reasons, not forecasting or adapting to possible changers. Not been proactive enough but reactive are few to name. A major area which attracted the lime light was the ‘Accounting sector’ mainly many critics pointed out that the reason for ‘Financial Giant’ to collapse was due to lack of correct (Legal) and ethical accounting practices, reflecting their true financial picture/status to the public. Financial reports at a glance provide the ‘profit and loss’ stance of a company, but to get the maximum leverage or insight knowledge one should be able to ‘read between the lines’ in accounting terms in an annual report. This is the point where they can use the ‘ratio analysis’ as a vital tool. Not only to analyze the profit/ loss but many other important factors. Understanding the cost effectiveness, capital and liability structure in long term and short term perceptive, effectiveness of assets management, income turnover of assets, etc. They had many ideas and views to approach this task, to show the effectiveness of the ratio analysis and at the end commonly agreed to focus our study on the ‘Hotel / tourism Industry’ where we selected two major (five star) hotels holding companies and the year 2010 as the year to conduct the study, based on their annual reports. There were many reasons behind this selection, as 2010 was a historical year for all Sri Lankans in which we as a nation had to face the peak of the civil war and with a sign of relief saw the end to the 30 year hard fought civil war, three major elections, flood, initiation of major investments, increase in tourists, etc. In a country like Sri Lanka though the share market does not reflect the true picture of the business functions, we have been able to loop the business and financial fluctuations logically and strategically to reflect the original purpose of the study. I hope that this comprehensive and descriptive ratio analysis will be able to give an in-depth insight to the industry and much other functionality in a more coherent and an accountable manner.
- 3. 2. INTRODUCTION TO THE INDUSTRY Sri Lanka is well-known around the world as being an attractive destination for travel and tourism, offering a wide range of experiences. The sector is a significant contributor to national income and has emerged as the 4th highest foreign exchange earner in the country. Gross earnings from tourism stood at US $ 384 million in 2010 an increase of 12.3 percent over 2009 making itself as the fast emerging growth industry in the economy. Recently New York identified Sri Lanka as the number one destination out of 31 to visit in the world in year 2010. The Sri Lankan tourism sector is gearing up for increased arrivals and higher average daily expenditure per tourist. It is also focusing on increasing room capacity and generating additional direct employment. 3. COMPANY PROFILES GALADARI HOTELS (LANKA) PLC. Coroporate Structure The hotel Galadari is situated in the heart of Colombo's business district, and accomplishes with 450super luxury rooms, that overlooks the Indian Ocean and is adjacent to leading Banks and the World Trade Center, with easy access to the shopping areas in Colombo. The Galadari Hotels (Lanka) Plc. offers a rich blend of service and quality in five star luxury living. Hotel ensure and meticulous about maintaining the privacy of its guests has drawn in many an elite personality from around the world such as heads of government, prime ministers of leading nations, royalty, well known sports & music personalities over the past two and half decades. With a range of room and suite types, and a comprehensive list of facilities, the hotel is able to cater to the requirements of both business and family travelers, and is especially geared to handle the needs of Muslim clients, with Halal food in all restaurants.
- 4. 4. INTRODUCTION TO FINANCIAL ANALYSIS OF GALADARI HOTEL (LANKA) PLC. This study is for examine specific characteristics in the financial analysis of Galadari Hotels (Lanka) PLC. It is a listed company in the Colombo Stock Exchange (CSE). The analysis is based on the following selected areas to identify whether the company assessed and carrying out their financial activities up to standards and also to evaluate and analysis the financial strengths and weaknesses of a firms by establishing meaningful relationships between the elements of financial statements. Selected areas are as follows; Profitability Ratio Liquidity Ratio Solvency Ratio Activity Ratio Market Ratio The Galadari Hotel is mainly operated well in Hotel industry by showing negative last five years and 2010 positively performed. The analysis of financial operation evaluations in relevant to Sri Lankan Accounting Standards are carrying base on 2009-2010 financial year. The analysis has mainly focused on financial ratio analysis which are we discussed in the class to evaluate financial strengths and weaknesses of firms by establishing meaningful relationships between the elements of financial statements. 5. ACCOUNTING RATIO ANALYSIS “Ratio Analysis: is expresses the relationship among selected items of financial statement data. A ratio expresses the mathematical relationship between on quantity and another. The relationship is expressed in terms of either a percentage, a rate or a simple proportion.” Few advantages and disadvantages of ratio analysis are listed below, 5.1 PROFITABILITY RATIOS Every firm is most concerned with its profitability. One of the most frequently used tools of financial ratio analysis is profitability ratios which are used to determine the company's bottom line. Profitability ratios show a company's overall efficiency and performance. These measures indicate whether the company is performing satisfactorily. They are used to measure the Advantages of Ratio Analysis Limitations of Ratio Analysis Assist investors to make effective investment decision. Effect of price changes Facilitates inter-firm comparison Limitations of financial statements Assist organization planning and forecasting Comparative study required: Profitability Ratio measures the results of the organization operations, performance and effectiveness.
- 5. performance of the management, to identify whether a company may be a worthwhile investment opportunity and to determine a company’s Performance relative to its competitors. Classifications of profitability ratios 5.1.1. Gross Profit Ratio Gross Profit Ratio indicates the amount of earnings, required to pay fixed costs and profits, are generated from revenues. Indicates how much of each sales rupee is available to meet expenses and profits after merely paying for the goods that were sold of an organization. The gross profit margin looks at cost of goods sold as a percentage of sales. This ratio looks at how well a company controls the cost of its inventory and the manufacturing of its products or services and subsequently passes on the costs to its customers. The larger the gross profit margin, the better for the company. Formula: Gross Profit Ratio = Gross Profit X 100 Net Sales Calculation and comparison of Gross Profit Ratios for Galadari Holtel PLC. Year 2010 2009 Gross Profit = 827,733,335 X 100 577,378,333 X100 Rs. 1,026,180,900 730,093,065 = 80.66% 79.08% According to the definition of gross profit ratio, the company who has generated the highest value of gross profit is best/ preferred, because gross margin should be adequate to cover-up other expenses of the company. According to the above analysis, Companies can be rank as below, In 2010 – Good 2009 - Average Profitability Ratios Gross Profit Ratios Return on Asset Ratios Return on Equity Ratios
- 6. 5.1.2. RETURN ON ASSETS RATIO Return on Assets Ratio is an overall measure of profitability. Because it measures the efficiency with which the company is managing its investment in assets and using them to generate profit. It measures the amount of profit earned relative to the firm's level of investment in total assets. Net Income is taken from the income statement and total assets are taken from the balance sheet. The higher the percentage is the better, because that means the company is doing a good job using its assets to generate sales. Formula: Return on Assets Ratio =Net Profit after Tax X100 Average or Total Assets Year 2010 2009 Return on Assets Ratio = 23,651,446 X 100 (351,985,121) X100 Rs. 8,271,789,383 8,081,784,320 = 2.85% (4.35) % CALCULATION AND COMPARISON OF RETURN ON ASSETS RATIOS INTERPRETATION OF PROFITABILITY RATIOS 5.1.3. RETURN ON ASSETS RATIO Hotel Galadari has generate in 2010, compare to 2009 return on assets ratio managed investments on assets and utilized them to generate disenable profit as low level. They have done negative ratio value compare to 2009 and they are in bad position in using their assets to generate the profits due to having huge loss making investment project under financial crisis situation as well as their profits are heavily affected from exchange losses. 5.1.4. RETURN ON STOCK HOLDER’S EQUITY RATIO Return on Stock Holder’s Equity Ratio is perhaps the most important of all the financial ratios to investors in the company. It measures the return on the money the investors have put into the company. This is the ratio potential investors look at when deciding whether or not to invest in the company. Net income comes from the income statement and stockholder's equity comes from the balance sheet. In general, the higher the percentage is the better; it shows that the company is doing a good job using the investors' money.
- 7. Formula: Return on Stock Holder’s Equity = Net Income X100 Average Common Stockholder’s Equity Year 2010 2009 Return on Stock Holder’s Equity = 23,651,446 X 100 (351,985,121) X100 Rs. 1,527,843,977 1,346,063,925 = 1.5% (26.15) % CALCULATION AND COMPARISON OF RETURN ON EQUITY RATIOS INTERPRETATION OF PROFITABILITY RATIOS 4. RETURN ON STOCK HOLDER’S EQUITY Management of the Galadari Hotels Plc is able to utilize investor’s money effectively and efficiently. Therefore the investors of Galadari Hotels PLC. Has taken the low level return on the capital that they have invested in to the company. And very poor return on equity ratio. There are unable to generate sufficient profits to pay off fair retunes to their investors’ mainly due heavy out flow of financial expenses based on interest payments for bank overdrafts, financial leases and term loans and administration expenses. 2. LIQUIDITY RATIOS A class of financial metrics that is used to determine a company's ability to pay off its short- terms debts obligations. Liquidity ratios measure the short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash. Short-term creditors such as bankers and suppliers are particularly interested in assessing liquidity. The ratios we can use to determine the company’s short-term debt-paying ability are the current ratio, the acid-test, receivable turnover and inventory turnover. Classifications of Liquidity ratios Liquidity Ratios Current Ratios Acid –Test (Quick) Ratio Debtor’s collection Period
- 8. 2.1. CURRENT RATIO The current ratio is a widely used measure for evaluating a company’s liquidity and short –term debt-paying ability. The ratio is computed by dividing current assets by current liabilities. The concept behind this ratio is to ascertain whether a company's short-term assets (cash, cash equivalents, marketable securities, receivables and inventory) are readily available to pay off its short-term liabilities (notes payable, current portion of term debt, payables, accrued expenses and taxes). The higher the current ratio, the better. Formula: Current Ratio = Current Assets Current Liabilities Year 2010 2009 Current Assets 453,771,761 239,416,915 Current Liabilities 632,017,071 347,183,942 Current Ratio 0.71 0.69 The current ratio is sometimes referred to as the working capital ratio; working capital is current assets minus current liabilities. The current ratio is a more dependable indicator of liquidity than working capital. The current ratio is only one measure of liquidity. It does not take into account the composition of the current assets. For example a satisfactory current ratio does not disclose the fact that a portion of the current assets may be tied up in slow-moving inventory. A dollar of cash would be more readily available to pay the bills than a dollar of slow- moving inventory. INTERPRETATION OF LIQUIDITY RATIOS FOR THE GALADARI HOTELS PLC. Hotel Gladari current ratios do not significantly vary in both comparable years. Though Company has an increase in 2010 and slightly decrease in the financial year 2009. Thus decrease in the current ratio represents that there has been deterioration in the liquidity position of the firm. 2.2. ACID-TEST (QUICK) RATIO The acid-test (Quick) ratio is a measure of a company’s immediate short-term liquidity. We compute this ratio by dividing the sum of cash, short-term investments and net receivables by current liabilities. Thus, it is an important complement to the current ratio.
- 9. Calculation and comparison of Acid –Test (Quick) Ratio Year 2009/2010 2008/2009 Cash and Cash Equivalents 67,832,667 93,687,036 Marketable securities 221,295,981 34,510,654 Accounts receivable 98138418 75940670 Current liabilities 632,017,071 316,724,410 High degree of Certainty Company will cash flow problem. Who is a man responsible having cash flow problem? 1. Managers not collecting cash on time 3. ACTIVITY RATIOS Activity ratios measure a firm's ability to convert different accounts (asset, liability or capital share) within their balance sheets into cash or sales (revenue). Companies will typically try to turn their production into cash or sales as fast as possible because this will generally lead to higher revenues. Activity ratios are critical in evaluating a company’s fundamentals because in addition to expressing how well a company generates revenue, activity ratios also indicate how well the company is being managed. CLASSIFICATIONS OF ACTIVITY RATIOS Quick Ratio Year Galadari Hotel 2010/2011 0.57 2009/2010 0.77 Activity Ratio measures the efficiency with which the recourses of a firm have been employed and its indicate the speed with which assets are being turned over into sales.. Activity Ratios Inventory/Stock Turnover Ratio Debtors / Receivables Turnover Ratio Assets Turnover Ratio
- 10. 3.1 RECEIVABLE TURNOVER It can measure liquidity by how quickly a company can convert certain assets to cash. The ratio used to assess the liquidity of the receivable is receivables turnover. It measures the number of times, on average; the company collects receivables during the period. Receivable Turnover = Sales Average Accounts Receivable (2010) = 1,026,180,900 (32,865,532 + 23,220,120) 2 = 1,026,180,900 56,085,652 = 1,026,180,900 56,085,652 = 36.59 They collect cash from the customers 36.59 (rounding off 37) times in a financial year. 3.1.2. Collection Period = 365 Receivable Turnover =365 36.56 9.975 = 10days Credit period is always 30days. This 10days collection period is not good for Galadari Hotels PLC. As a five star hotel. Otherwise collection can be going down. 3.3 INVENTORY TURNOVER Inventory / Stock Turnover Ratio indicates the number of time the stock has been turned over during the period and evaluates the efficiency with which a firm is able to manage its inventory. This ratio indicates whether investment in stock is within proper limit or not. It measures the number of times, on average; the inventory is sold during the period. Its purpose is to measure the liquidity of the inventory. Inventory Turnover = Cost of Goods Sold Average inventory = 198,447,565 129,229,093 + 99,432,385 2
- 11. = 198,447,565 228,661,481 = 0.86 3.4 HOLDING PERIOD HOLDING PERIOD = 365 Inventory Turnover = 365 0.86 =424 days Always industry holding period average is 50days. This situation is bad that’s why Galadari Hotels PLC. 3.5 ASSET TURNOVER RATIO Asset Turnover Ratio measures the revenue that is generated for every rupee of asset owned by the company. Asset turnover ratios help to measure the effectiveness with which the company/management uses its assets to generate sales or revenue. These ratios help to measure the productivity of a company's assets Asset Turnover = Total Sales Average total Assets = 1,026,180,900 453,771,761 + 239,416,915 2 = = 1,026,180,900 693,188,676/2 = 1,026,180,900 346,594,338 = 2.96
- 12. 4. MARKET RATIOS Market ratios measure the investor response to owning a company's stock and also the cost of issuing stock. A market-value ratio is a metric used to gauge a company's viability in terms of such variables as profitability and the market valuation of its stock. These ratios are used analytically by a company's management as well as by its current and prospective investors. A market-value ratio also acts as an indicator that expresses the value of a company's stock in terms of a specific item in its financial statements. Different ratios indicate a company's viability, or financial health, where asset values, revenue, income, and ability to pay bills are concerned. Classifications of Market ratios 4.1 EARNINGS PER SHARE Earnings per share (EPS) the portion of a company's profit allocated to each outstanding share of common stock. Earnings per share serve as an indicator of a company's profitability. Basic Earnings per share is calculated by dividing the net loss for the year attributable to ordinary shareholders by the weighted average number of ordinary shares outstanding during the year. The weighted average number of ordinary shares outstanding during the year and previous year are adjusted for events that have change the number of ordinary shares outstanding, without a corresponding change in the resources such as a bonus issue. Formula EPS = Net Profit after Tax Average Number of issued ordinary shares Calculation and Interpretation of Earnings per share Ratios Market Ratios Earnings per share Ratios Dividends Payout Ratios Price Earnings Ratios
- 13. Financial Data/ Year 2010 2009 Profit/Loss after Tax 23,651,446 -351,985,121 Average Number of issued ordinary shares 182,434,060 182,433,060 EPS 0.13 (1.93) Earnings per share ratio signify the amount of earnings available for the investors who have been invested or willing to invest in equity shares of the company. This ratio gives the amount of earnings can be attribute to a single share of the company. 4.2 PRICE EARNINGS RATIO The Price-to-Earnings ratio (P/E ratio) of a stock is a measure of the price paid for a share relative to the annual net income or profit earned by the firm per share. (P/E) ratio indicates the value of a company's stock relative to its financial performance. It is sometimes called a multiple because it indicates the amount of money that must be invested in order to derive one dollar of earnings. For this reason, lower ratios are preferred to higher ones. Formula Price Earnings Ratio = Market Price per Share Earnings per Share Calculation and Interpretation of Price Earnings Ratios for three companies Financial Data/ Year 2010 2009 Market Value per share (Rs.) 10 15 EPS(Rs.) 0.13 (1.93) P/E Ratio 76.92 -7.7 The calculated P/E Ratio reflects that the Galadari Hotels PLC. Earings in positive after 4 years as Rs. 76.92/- . Due to the face that Galadary having after tax loss it has resulted with an negative EPS in 2009. A higher P/E ratio means that investors are paying more for each unit of net income, so the stock is more expensive compared to one with lower P/E ratio. The P/E ratio has units of years which can be interpreted as "number of years of earnings to pay back purchase price. If we consider the number of years to pay up the purchase value of the share by its earnings, hypothetically for an investors of Galadari hotels Plc it takes 76.92 if the company continues to earn current level of profits.
- 14. 5. PERFORMANCE OVERVIEW OF GALADARI HOTELS (LANKA) PLC.: During the financial year ended December 2010, the Group achieved revenues of Rs. 1026 million. The turnover for the year under review was Rs. 1,026,180,900/- while the Gross Profit was Rs. 827,733,335/-, resulting in a 41% increase in the turnover and 43% increase in the Gross Profit Comparison with year 2009. Stated Capital Rs. 1.8 billion Market value per share is Rs. 15.00 Earnings per share is Rs. (0.13) Share Capital as at 31st December 2010 –Rs. 1,527,844/- The reconstruction of the Hotel continued throughout the year 2010. 6. CONCLUSION The various ratios that have been identified in determining a financial situation can be categorized in to Galadari Hotels PLC. Elements i.e. Profitability Ratio, Liquidity ratio, Solvency ratio, Activity and Market ratio. As described in the introduction each of these ratios play a specific function with reference to the functionality and the status quo of an organization. In the case of the specific exercise, the hotel industry has been selected and the annual report of the Galadari Hotel PLC has been analyzed. The profiles of the companies have been shown in the introduction and the annual reports have been annexed. Profitability ratio: Every firm is most concerned with its profitability. One of the most frequently used tools of financial ratio analysis is profitability ratios which are used to determine the company's bottom-line. The profitability ratios are then categorized in to several other ratios: Gross profit, Net profit, return on asset, return on equity and return on capital employed. The importance of these ratios is that to an investor the ratios give information on the general direction of the identified company. The investor can then decide whether to hold, buy or sell his or her shares. Also based on the ratios the investor can identify if a company has over borrowed or if the company can meet its short term liquidity issues. The shareholders know whether the on track as expected are entitled to dividend. Hence when considering the profitability ratio, the most profitable entity is in 2010 than 2009 in Galadari Hotels PLC. Hence the company represents comparatively sound ratios.
- 15. REFERENCE GALADARI HOTELS (LANKA) PLC. Annual Report year of 2010 www.cse.lk/cmt/upload_report_file/532_1274867640886.pdf www.cse.lk/cmt/upload_report_file/690_1275657128533.pdf
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Ratio analysis helps to analyze and assess the overall financial performance of a company. For this financial statement case study analysis assignment help paper, Abercrombie & Fitch Co, American retailer company that provides casual wear for customer in United States, is selected for which two years financial ratios are calculated for analysis (Abercrombie & Fitch, 2012). To evaluate the overall performance of company profitability, liquidity and leverage ratio are calculated that will help to assess and compare financial performance over the period.
The above appendix shows that the overall financial performance of Abercrombie & Fitch has decreased in 2011 in compare to last year because of decline in profitability ratios. Decline in net income, gross margin and return on shareholder’s equity return shows that the business is going towards decline that is not suitable for investors. It shows that financial performance is not good.
Current ratio and quick ratio of Abercrombie & Fitch Co has declined over the last year because of increase in current liabilities at higher rate as compared to current assets. Decline in liquidity ratio indicates that company has faced shortage of sufficient cash to pay its short-term liabilities and working capital in the business (Nikolai, Bazley & Jones, 2009). Quick ratio and inventory turnover ratios represent that increase in inventory affect the ability of organization to meet short term obligations due to increase in investment in inventory that may cause an increase overall cost of business.
Debt to assets and debt to equity ratios represent that Abercrombie & Fitch’s total debt has decreased over the last year. Decline in debt percentage represent that organization is financed by internal capital rather than external capital that reduces overall risks and increases solvency position of organization in long-term (Bragg, 2012). Firm’s equity has increased, but due to decline in profit, its earnings per share have decreased. It indicates negative growth of earning on each share that means company’s overall performance is declining in compare to last year. On the other hand, it cannot generate appropriate return for the investors that may affect interest of shareholders.
Investment Decision Investment should be taken by considering several aspects and organization financial performance into consideration. Abercrombie & Fitch’s overall financial performance has decreased over the last year that indicates shareholders are not earning sufficient return on investment. Investor should not invest in Abercrombie & Fitch because company’s profitability has declined in compare the past year and consequently the value of shareholders too as return on equity has declined from 8.22% to 6.75% in 2011 from 2010. Investors also need to be aware of earning manipulation, while taking investment decision (Axelby, 2003). The decline in EPS from 1.71 per share to 1.45 per share and liquid also create a risk for investors. References Abercrombie & Fitch. (2012). Investors . Retrieved from: http://www.abercrombie.com/anf/investors/investorrelations.html Abercrombie & Fitch. (2012). Retrieved from: www.Abercrombie.com Axelby, G. (2003). CIM Coursebook 02/03 Management Information for Marketing Decisions . Italy: Taylor & Francis. Bragg, S.M. (2012). Business Ratios and Formulas: A Comprehensive Guide (3 rd ed.). USA: John Wiley & Sons. Nikolai, L.A., Bazley, J.D. & Jones, J.P. (2009). Intermediate Accounting (11 th ed.). USA: Cengage Learning. How to get Financial Ratio Analysis Assignment Help with assignmenthelpexperts.com Assignmenthelpexperts.com is the place where students can get assignment writing services from qualified and experienced assignment writers of US, UK and Australia. Students who need any topic academic assignment help can touch with our 24X7 live support system or can send e-mail at [email protected]
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Financial Ratios
The use of financial figures to gain significant information about a company
What are Financial Ratios?
Financial ratios are created with the use of numerical values taken from financial statements to gain meaningful information about a company. The numbers found on a company’s financial statements – balance sheet , income statement , and cash flow statement – are used to perform quantitative analysis and assess a company’s liquidity, leverage, growth, margins, profitability, rates of return, valuation, and more.
Financial ratios are grouped into the following categories:
- Liquidity ratios
- Leverage ratios
- Efficiency ratios
- Profitability ratios
- Market value ratios
Uses and Users of Financial Ratio Analysis
Analysis of financial ratios serves two main purposes:
1. Track company performance
Determining individual financial ratios per period and tracking the change in their values over time is done to spot trends that may be developing in a company. For example, an increasing debt-to-asset ratio may indicate that a company is overburdened with debt and may eventually be facing default risk.
2. Make comparative judgments regarding company performance
Comparing financial ratios with that of major competitors is done to identify whether a company is performing better or worse than the industry average. For example, comparing the return on assets between companies helps an analyst or investor to determine which company is making the most efficient use of its assets.
Users of financial ratios include parties external and internal to the company:
- External users: Financial analysts, retail investors, creditors, competitors, tax authorities, regulatory authorities, and industry observers
- Internal users: Management team, employees, and owners
Liquidity Ratios
Liquidity ratios are financial ratios that measure a company’s ability to repay both short- and long-term obligations. Common liquidity ratios include the following:
The current ratio measures a company’s ability to pay off short-term liabilities with current assets:
Current ratio = Current assets / Current liabilities
The acid-test ratio measures a company’s ability to pay off short-term liabilities with quick assets:
Acid-test ratio = Current assets – Inventories / Current liabilities
The cash ratio measures a company’s ability to pay off short-term liabilities with cash and cash equivalents:
Cash ratio = Cash and Cash equivalents / Current Liabilities
The operating cash flow ratio is a measure of the number of times a company can pay off current liabilities with the cash generated in a given period:
Operating cash flow ratio = Operating cash flow / Current liabilities
Leverage Financial Ratios
Leverage ratios measure the amount of capital that comes from debt. In other words, leverage financial ratios are used to evaluate a company’s debt levels. Common leverage ratios include the following:
The debt ratio measures the relative amount of a company’s assets that are provided from debt:
Debt ratio = Total liabilities / Total assets
The debt to equity ratio calculates the weight of total debt and financial liabilities against shareholders’ equity:
Debt to equity ratio = Total liabilities / Shareholder’s equity
The interest coverage ratio shows how easily a company can pay its interest expenses:
Interest coverage ratio = Operating income / Interest expenses
The debt service coverage ratio reveals how easily a company can pay its debt obligations:
Debt service coverage ratio = Operating income / Total debt service
Efficiency Ratios
Efficiency ratios, also known as activity financial ratios, are used to measure how well a company is utilizing its assets and resources. Common efficiency ratios include:
The asset turnover ratio measures a company’s ability to generate sales from assets:
Asset turnover ratio = Net sales / Average total assets
The inventory turnover ratio measures how many times a company’s inventory is sold and replaced over a given period:
Inventory turnover ratio = Cost of goods sold / Average inventory
The accounts receivable turnover ratio measures how many times a company can turn receivables into cash over a given period:
Receivables turnover ratio = Net credit sales / Average accounts receivable
The days sales in inventory ratio measures the average number of days that a company holds on to inventory before selling it to customers:
Days sales in inventory ratio = 365 days / Inventory turnover ratio
Profitability Ratios
Profitability ratios measure a company’s ability to generate income relative to revenue, balance sheet assets, operating costs, and equity. Common profitability financial ratios include the following:
The gross margin ratio compares the gross profit of a company to its net sales to show how much profit a company makes after paying its cost of goods sold:
Gross margin ratio = Gross profit / Net sales
The operating margin ratio , sometimes known as the return on sales ratio, compares the operating income of a company to its net sales to determine operating efficiency:
Operating margin ratio = Operating income / Net sales
The return on assets ratio measures how efficiently a company is using its assets to generate profit:
Return on assets ratio = Net income / Total assets
The return on equity ratio measures how efficiently a company is using its equity to generate profit:
Return on equity ratio = Net income / Shareholder’s equity
Learn more about the different profitability ratios in the following video:
Market Value Ratios
Market value ratios are used to evaluate the share price of a company’s stock. Common market value ratios include the following:
The book value per share ratio calculates the per-share value of a company based on the equity available to shareholders:
Book value per share ratio = (Shareholder’s equity – Preferred equity) / Total common shares outstanding
The dividend yield ratio measures the amount of dividends attributed to shareholders relative to the market value per share:
Dividend yield ratio = Dividend per share / Share price
The earnings per share ratio measures the amount of net income earned for each share outstanding:
Earnings per share ratio = Net earnings / Total shares outstanding
The price-earnings ratio compares a company’s share price to its earnings per share:
Price-earnings ratio = Share price / Earnings per share
Related Readings
Thank you for reading CFI’s guide to financial ratios. To help you advance your career in the financial services industry, check out the following additional CFI resources:
- Analysis of Financial Statements
- How the 3 Financial Statements are Linked
- Comparable Company Analysis
- Types of Financial Models
- See all accounting resources
- See all capital markets resources
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Unique Submission
- Posted on September 17, 2020
- Unique Submission Team
Financial Analysis
Introduction
In this competitive environment, it is essential for the companies to increase the knowledge about the financial terms with respect to evaluate the different financial activities of the business.
This knowledge helps the organization to analyze the market trend related to finance within the competitive market (Walker, 2009). In this way, the main focus of this report is to make a comparison report that can help to show the comparison between two organizations that are working in the same industry.
For accomplishing the purpose of this report, Apple Inc. as a primary company is selected that is listed in the S & P 500. In addition, for comparing performance, Intel is selected as the secondary company that helps to present the comparison with Apple Inc by using trend analysis and ratio analysis techniques.
This report starts with the introduction of both selected companies. This report also highlights the financial performance of both companies that define the company’s financial position with a historical trend within the market.
Moreover, the ratio analysis is also used in this report in context to analyze the financial performance of the companies of last five years. For conducting the comparison between both the companies, different ratios such as liquidity ratio, efficiency ratio, profitability ratio and capital structure ratio and investment ratios are used.
Company Background
Apple Inc. is an American multinational technology company that is founded by Steve Jobs in 1976. Apple has it’s headquartered in Cupertino, California US that serves its users by its IT products and services.
The company works in the information technology industry and provides high quality and performance products as well as services related to IT to its users. At the same time, Apple provides its different products like computer software, computer hardware, digital distribution, consumer electronics etc in different segments.
In the concern of its financial position, the total revenue of Apple Inc. was recorded as $229.234 billion in the financial year 2017. It provides the employment of more than 123,000 employees in its different segments.
In order to compare the performance of Apple, Intel is a well-known company in the information technology industry. It is headquartered in the same area as Apple. Further, the main source of revenue of Intel is its processors that are used in the computers.
In context to evaluate and analyze the financial performance of Apple last five years, the technique of ratio analysis is really helpful. This ratio is also helpful to make the comparison of the financial performance between Apple Inc and its market competitor Intel.
a) Historical trends in accounting statement entries
In order to determine trends in the accounting statement entries, it is required to conduct trend analysis. For Apple, the following table presents trend analysis by considering income statement, balance sheet, and cash flow statements:
Table 1: Historical Trends of Apple
(Source: Annual Report, 2017a, Annual Report, 2017b, Yahoo Finance, 2018a & Yahoo Finance, 2018b)
Based on the above table, it can be stated that overall, there is an increasing trend in the accounting statement entries from 2014 to 2017 with respect to the base year 2013.
In addition, there is an increasing trend from 2013 to 2015 for all considered accounting statement entries like turnover, profit, long-term debt, cash and cash equivalents, equity, cash flow from operations and dividends.
But at the same time, there is a decline in revenue, gross profit, operating profit, net profit, cash and cash equivalents, and cash flow from operations in 2016 as compared to 2015 due to decline in unit sales and net sales of iPhone units and effect of weakness in foreign currencies relative to the U.S. dollar.
However, values of all these entries increased in 2017 showing an increasing trend as compared to 2016.
Table 2: Historical Trends of Intel
On the other hand, it can be analyzed that there is an increase in total revenue, gross profit, operating income and net profit in 2014 as compared to the base year 2013, however, these values decreased in 2015.
But at the same time, there is a decline in long-term debt, cash and cash equivalents and stakeholder equity, cash flow from operating activities and dividends in the year 2014 in comparison of the base year 2013 followed by an increase in 2015.
However, after this, there is an increasing trend in revenue, gross profit, operating profit, equity, cash flow from operations and dividends from 2015 to 2017 consistently, but a decline in net profit, cash, and cash equivalents is noticed in the year 2017 due to high investment in R&D and strategic alliances with other firms.
b) Historical trends and inter-company comparisons of relevant accounting ratios
This section presents the historical trends and inter-company comparisons of different accounting ratios of Apple and Intel.
Liquidity ratios:
Liquidity ratio provides the information related to the potential of the firm to meet the short-term obligations (Keating, 2014). The below table shows the calculated liquidity ratio of both firms:
Table 3: Liquidity Ratios
From the above table, it can be stated that there is a decline in the current ratio of Apple (from 1.68 to 1.28) as well as Intel (from 2.36 to 1.69) from the year 2013 to 2017 with some fluctuations. But at the same time, the current ratio of both firms is above 1 showing the ability of both firms to meet their current obligations effectively, but it is not equal to ideal ratio of 2:1.
Meanwhile, Intel current ratio is higher than Apple showing better ability of Intel as compared to Apple to meet its short-term obligations. The lower current ratio of Apple as compared to Intel might be due to sharp increase in the short term debts without significant increase in the short-term assets.
In addition, the quick ratio of both firms is more than 1 but with declining trend during this period (for Apple, from 1.64 to 1.23; for Intel, from 2.06 to 1.29).
However, it is higher for Intel in comparison of Apple showing better ability of the firm to meet its short-term obligations in contingency (Edmonds et al., 2015). It is because there might be possibility of increasing short-term debts for Apple.
It also indicates that both companies can settle their short-term debts for more than 1 time without considering the inventories. However, there is better consistency in the liquidity of Apple due to fewer fluctuations as compared to Intel.
Profitability ratios:
These ratios provide the information related to the profitable situation of the company to generate sufficient returns for the investors (Petty et al., 2015). The below table shows the calculated profitability ratio of both firms:
Table 4: Profitability ratios
Regarding these ratios, it can be interpreted that there is a decline in return on capital employed (from 29.58% to 22.35%) and net profit margin (from 21.68% to 21.09%) from 2013 to 2017 for Apple, but there is an increase in return on equity (from 40.60% to 47.81%) during this period. The increase in return on equity may be associated with finance access by Apple in procurement of assets as costs incurred on borrowing.
However, there is a significant increase in return on capital employed (from 1.59% to 16.95%) and return on equity (from 21.64% to 29.49%), but a decline in net profit margin (from 18.25% to 15.30%) is also noticed from 2013 to 2017 for Intel.
The decline in net profit for both companies was because of rising cost of operations including R&D and depreciation of assets that largely affected the net profits of the firms. So, it is crucial for the management of both firms to take measures for reducing operating expenses.
But at the same time, the values of all profitability ratios are higher for Apple as compared to Intel during this period. It suggests that Apple is capable of generating higher profits as compared to Intel for its investors (Warren et al., 2013).
Efficiency Ratios:
These ratios provide the information related to the efficiency of the management to use the available resources including inventory and assets to increase sales (McKinney, 2015). In concern of these ratios, the following table presents the efficiency of the management of both firms:
Table 5: Efficiency ratios
In relation to inventory ratio, it can be depicted that the inventory turnover ratio for Apple (from 60.76% to 29.05%) as well as Intel (from 5.14% to 3.39%) declined from the year 2013 to the year 2017.
It might be due to significant increase in sales as compared to inventories of both firms with some fluctuations. However, it is higher for Apple showing the efficiency of the management to convert inventory into sales faster in comparison to Intel due to high innovation and quality focus on production.
It also shows that Apple is a labour intensive company or it adds value to brought-in products and converts its inventory into sales in shorter period as compared to Intel.
At the same time, the asset turnover ratio for both firms how high fluctuations but overall, there is a decline in asset turnover for Apple (from 105% to 84%) and Intel (from 67% to 59%) during this period indicating declining ability of the management to utilize and convert the assets into sales (Graham and Smart, 2011).
However, the value of asset turnover is higher for Apple in comparison to Intel showing the higher efficiency of Apple’s management to convert assets into sales. It means Apple uses assets efficiently to convert them into sales in less time period as compared to Intel.
Capital Structure ratios:
Capital structure ratio is related to the ratio reflecting the fund arrangement of the firm. It shows the ability of the firm to manage the capital structure effectively (Keating, 2014). The below table shows the comparison between capital structure ratio of Apple and Intel:
Table 6: Capital Structure ratios
From the above table, it can be stated that there is an increase in debt to asset ratio of Apple (0.4 to 0.64) and Intel (from 0.37 to 0.44) from the year 2013 to the year 2017 showing the increasing contribution of debt in capital structure as both firms have increased the investment in R&D and advanced technologies more.
However, the value of debt to asset ratio for Apple is higher than Intel reflecting higher debt portion in capital structure as compared to Intel. The same results are obtained in relation to debt to equity ratio as this ratio for Apple (from 0.68 to 1.8) and Intel (from 0.59 to 0.79) increased during this period indicating the increasing contribution of debt in the capital structure.
However, it also shows that debt to equity ratio is higher for Apple or more than 1 means company uses more debt as compared to equity in its capital structure to keep the financing cost low, protect the shareholders and make large investments in R&D and innovative projects (Droms and Wright, 2010).
But the debt to equity ratio is less than 1 for Intel as the company uses more equity in its financing to increase its creditworthiness for future contingency. The regular increase in debt ratio during this period for both companies shows that both companies appear to be improving its debt position.
Interest cover ratio of Apple declined over the years from 355 to 26.41 significantly at the same time, there is slight decrease in this ratio from 29 to 28 for Intel. However, it is higher for both firms imply ability of both firms to pay their interests easily. But, in 2017, interest coverage ratio is slightly higher for Intel as compared to Apple as Intel finds it easier to meet its interest payments as compared to Apple.
Stock Market Ratio:
Investment ratios are significant to provide the information related to returns on investment by the company to the investors that help them to make investment decisions. In relation to Apple and Intel, the below table presents the calculated investment ratios:
Table 7: Stock market ratios
Based on the above table, it can be analyzed that EPS for Apple has been increasing from $5.66 in 2013 to $ 9.21 in 2017 with fluctuation in the year 2016 due to impact on revenues by the competitors showing an increasing trend and ability of the firm to provide higher stock returns.
But at the same time, the company’s dividend per share declined from $11.80 in 2013 to $ 2.03 in 2015 but after this, it increased up to $2.46 till 2017. It shows that from 2013 to 2015, company reinvested its profits in R&D and new product development more affecting the dividend per share but after this, it started to increase this return to the shareholders to remain its stock attractive for the investors.
On the other hand, EPS and DPS of Intel are less as compared to Apple showing the lower ability of the firm to generate adequate stock returns comparatively. However, EPS (from $1.88 to $1.99) and DPS (from $ 0.90 to $1.12) both increased from the year 2013 to the year 2017 indicating the increasing ability of the firm to generate stock returns on its shares for the investors (Brigham & Ehrhardt, 2013).
Based on the above analysis and discussion, it can be summarized that Apple is performing better than Intel but at the same time, the financial performance of Apple is declining due to increasing competition and changing customers’ preferences.
In addition, it is also concluded that historical trends showed that both companies have fluctuations in trends of accounting statement entries. At the same time, ratio analysis reflects that Apple has higher liquidity, profitability and efficiency and investment ratios as compared to Intel and uses more debt in its capital structure as compared to Intel.
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A Complete Tutorial On Ratio Analysis In Accounting
Introduction
In accounting, ratio analysis refers to a method that helps companies to gain insight into their liquidity, profitability, and operational efficiency by comparing financial data and information included in their financial statements. Ratio analysis stands as a cornerstone of a company’s fundamental analysis. Also, Companies use this analysis for evaluating relationships among the items of their financial statements (Delen, Kuzey & Uyar, 2013). However, these ratios are also used for identifying a company’s trends in relation to profitability, liquidity, and solvency over time or for comparing two/more companies at the same point in time. The current essay is constructed to provide a complete tutorial on ratio analysis. You can consider it as a financial accounting assignment help guide as well.
Main Body/Discussion
Ratio analysis is conducted by considering a company’s financial statement and it uses to focus on three major aspects such as profitability, liquidity, and solvency. In fact, these ratios help potential shareholders or investors to gauge a company’s financial performance over a certain period of time by comparing its financial performance with another company before finalizing investment decisions (Babalola & Abiola, 2013). Now, outside business analysts use different types of financial ratios for assessing companies, whereas insiders of a corporate rely less on these ratios because they have access to more detailed operational and financial data about their company.
However, this analysis involves evaluating a company’s financial performance and health by using its financial data as available in its historical and current financial statements. Sometimes, this analysis is used in order to establish a trend-line on the basis of a company’s financial results over a number of financial years i.e. reporting periods.
The major categories of financial ratios are discussed below including formulas.
Profitability Ratios
Profitability ratios refer to the financial metrics that are used by investors and analysts to evaluate and measure a company’s ability to generate profit (income) relative to its revenue, operating costs, shareholders’ equity, and balance sheet assets during a certain period of time. Also, these ratios show how well an organization uses its assets for producing profit as well as value to its shareholders. Profitability ratios are categorized into margin ratios and return ratios.
Margin ratios
This category of profitability ratios includes i) Gross profit margin that compares a company’s gross profit from the business to its sales revenue. It shows a business’s earning by taking the required costs of production into account. ii) Operating profit margin that looks at a company’s earnings (operating profit) as a % of sales before deducting income taxes and interest expenses. iii)However, Net profit margin, the most vital profitability ratio that looks at the net income (after deducting taxes and interest from operating profit) of a company and compares it to total revenue, and provides a final picture of a company’s profitability.
iv) EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) margin that represents a company’s profitability before taking non-operating elements like interest, taxes, and non-cash items such as amortization and depreciation into account. v) Cash flow margin that uses to express the relationship between a company’s sales and cash flows it generates from its operating activities. Also, this ratio measures a company’s ability to convert its sales into liquid cash. However, the higher this ratio, the more cash available to a company from sales which it can use to pay dividends, suppliers’ dues, utilities, service debt, and for purchasing capital assets (corporatefinanceinstitute.com, 2020).
Read Also- What is the major objective of managerial accounting?
Return ratios
In order to solve the finance assignment dealing with financial ratios in accounting, you must be well versed with the basics which go like this. i) ROA (return on assets) that represents the % of a company’s net income relative to its total assets and reveals how much profit (after-tax profit) a company uses to generate for every single dollar of assets it holds. Also, it measures a company’s asset intensity. ii) ROE (return on equity) which uses to express the % of a company’s net profit relative to its stockholders’ equity or the percentage of return equity investors can get on on the money they have invested into a company.
The investors and stock analysts use to focus on this ratio. iii) ROIC (return on invested capital) that measures the return generated by a company compared to the capital, raised from shareholders and bondholders, it has invested in its business ( corporatefinanceinstitute.com , 2020).
Liquidity Ratios
These ratios measure a company’s ability to pay off its short‐term financial obligations or debts and to meet its unexpected cash requirements. Accordingly, the analysis of liquidity ratios is very important for creditors and lenders who want to get some ideas regarding a company’s financial condition before granting credit to it. In fact, the most commonly used liquidity ratios are the current ratio, quick ratio, and working capital ratio. Also, the current ratio represents the ability of a company to meet its short-term debt or financial obligations and measures whether the company holds enough resources that it can use to repay its debts in the next twelve months.
The quick ratio measures the ability of a company to meet all its short-term financial obligations by using liquid assets (cash or quickly convertible assets) it holds. Consequently, it tells about the short-term debts of a company that it can repay by selling its liquid assets at short notice to the creditors. However, the working capital ratio is used for measuring a company’s capability to meet its current financial obligations and how many liquid assets are available in a company’s hands (Brigham & Ehrhardt, 2013).
Solvency Ratio
The solvency ratio measures a company’s ability to meet its long-term debts. Moreover, it quantifies a company’s size after its tax income without counting its non-cash expenses for depreciation. It indicates a company’s solvency by judging its financial health. There are some common solvency ratios that are used for checking a company’s solvency such as debt-to-equity ratio, debt-to-asset ratio, and debt-to-capital ratio.
The debt-to-equity ratio indicates the relative proportion of debts and shareholders’ equity a company uses to finance its assets. The debt-to-assets ratio indicates the financial leverage of a company. It indicates how much of the total assets of a company were purchased or financed by its creditors. the debt-to-capital ratio measures the financial leverage of a company and is calculated by dividing interest-bearing debt (both short-term and long-term liabilities) and by the company’s total capital (all interest-bearing debt + shareholders’ equity) (Khidmat & Rehman, 2014).
Efficiency Ratios
These ratios measure the capability of a company to utilize its assets as well as to manage its corporate liabilities effectively in a short-term period or for the current financial period. Some of the most common efficiency ratios are inventory turnover ratio that indicates the movement or utilization of inventory, accounts turnover ratio which indicates how fast a company collects its dues from its customers, and assets turnover ratio that uses to measure the value of an organization’s revenue or sales relative to the value of assets it holds.
This ratio acts as an indicator of a company’s efficiency in using assets for revenue generation purposes. A higher asset turnover ratio indicates the greater efficiency of a company. Another efficiency ratio is accounted payables turnover ratio that uses to measure the faster a company repays its trade suppliers. It indicates a company’s financial condition by indicating the speed of the company’s activity to repay dues (Babalola & Abiola, 2013).
This essay is fully equipped with the key financial ratios used by business analysts, investors, and other stakeholders to gauge a company’s financial performance for the current year or for a certain period of time. Financial ratio analysis guides investors to select the most profitable company to invest in and helps creditors and other loan-providing organizations to decide where it is profitable for them to grant loans to a company or not. Overall, analysis of financial ratios is very helpful to understand a company’s financial statements, identify trends over the years and measure its actual financial state.
Read Also- Revenue Expenditure: Full Explanation
Examples of Ratio used in Financial Analysis
There are different types of possible ratios that can be used for analysis purposes. But there is only a small core group that is typically used to gain an understanding of an entity. Such ratios include the following-
- Current Ratio : These types of ratios are used to compare the current assests to current liabilities. This happens to see that whether a business has enough cash to pay its immediate liabilities.
- Days Sales Outsatnding: These types of ratios are used to determine the ability of a business to effectively issue credit to the customers and also to be paid back on the given peiod of time.
- Debt to Equity Ratio: This usually compares the proportion of debt to equity, to see if a business has taken on too much debt.
- Dividend Payout Ratio: This is usually the percentage of earning that are paid to investors in the form of dividends. If the percentage is low, then it will be an indicator that there is no room left for the dividend payments that could increase the sustainability.
- Gross Profit Ratio: This ratio is probably used for calculating the proportion of earnings generated by the sale of goods or services., before the administrative expenses are included.
- Inventory Turnover: This is used to calculate the the time it takes to sell of the inventory. A low turn over may figure out that a business has an excessive investment in inventory, and therefore is at risk of having obsolete inventory.
- Net-Profit Ratio: This is used to calculate the proportion of net profit to sales. A low proportion can indicate the bloated cost structure or pricing pressure.
- Price Earning Ratio: This is used to compare the price paid for a company’s shares to the earnings reported by the business. An excessively high ratio signals that there is no basis for a high stock price, which could presage a stock price decline.
- Return on assests: This is used to calculate the ability of management to efficiently use assests that could generate the profits. In case there is low return then it indicated that there is a bloated investment in assets.
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How to Analyze Your Business Using Financial Ratios
Using a sample income statement and balance sheet, this guide shows you how to convert the raw data on financial statements into information that will help you manage your business_
Many small and mid-sized companies are run by entrepreneurs who are highly skilled in some key aspect of their business—perhaps technology, marketing or sales—but are less savvy in financial matters. The goal of this document is to help you become familiar with some of the most powerful and widely-used tools for analyzing the financial health of your company.
Some of the names—"common size ratios" and "liquidity ratios," for example—may be unfamiliar. But nothing in the following pages is actually very difficult to calculate or very complicated to use. And the payoff to you can be enormous. The goal of this document is to provide you with some handy ways to look at how your company is doing compared to earlier periods of time, and how its performance compares to other companies in your industry. Once you get comfortable with these tools you will be able to turn the raw numbers in your company's financial statements into information that will help you to better manage your business.
For most of us, accounting is not the easiest thing in the world to understand, and often the terminology used by accountants is part of the problem. "Financial ratio analysis" sounds pretty complicated. In fact, it is not. Think of it as "batting averages for business."
If you want to compare the ability of two Major League home-run sluggers, you are likely to look at their batting averages. If one is hitting .357 and the other's average is .244, you immediately know which is doing better, even if you don't know precisely how a batting average is calculated. In fact, this classic sports statistic is a ratio: it's the number of hits made by the batter, divided by the number of times the player was at bat. (For baseball purists, those are "official at-bats," which is total appearances at the plate minus walks, sacrifice plays and any times the player was hit by a pitch.)
You can think of the batting average as a measure of a baseball player's productivity; it is the ratio of hits made to the total opportunities to make a hit. Financial ratios measure your company's productivity. There are many ratios you can use, but they all measure how good a job your company is doing in using its assets, generating profits from each dollar of sales, turning over inventory, or whatever aspect of your company's operation that you are evaluating.
Financial Ratio Analysis
The use of financial ratios is a time-tested method of analyzing a business. Wall Street investment firms, bank loan officers and knowledgeable business owners all use financial ratio analysis to learn more about a company's current financial health as well as its potential.
Although it may be somewhat unfamiliar to you, financial ratio analysis is neither sophisticated nor complicated. It is nothing more than simple comparisons between specific pieces of information pulled from your company's balance sheet and income statement.
A ratio, you will remember from grammar school, is the relationship between two numbers. As your math teacher might have put it, it is "the relative size of two quantities, expressed as the quotient of one divided by the other." If you are thinking about buying shares of a publicly-traded company, you might look at its price-earnings ratio. If the stock is selling for $60 per share, and the company's earnings are $2 per share, the ratio of price ($60) to earnings ($2) is 30 to 1. In common usage, we would say the "P/E ratio is 30."
Remember that the ratios you will be calculating are intended simply to show broad trends and thus to help you with your decision-making. They need only be accurate enough to be useful to you. Don't get bogged down calculating ratios to more than one or two decimal places. Any change that is measured in hundredths of a percent will almost certainly have no meaning. Make sure your math is correct, but don't agonize over it.
A ratio can be expressed in several ways. A ratio of two-to-one can be shown as:
2:1 2-to-1 2/1
In these pages, when we present a ratio in the text it will be written out, using the word "to." If the ratio is in a formula, the slash sign (/) will be used to indicate division.
Types of Ratios
As you use this guide you will become familiar with the following types of ratios:
One of the most useful ways for the owner of a small business to look at the company's financial statements is by using "common size" ratios. Common size ratios can be developed from both balance sheet and income statement items. The phrase "common size ratio" may be unfamiliar to you, but it is simple in concept and just as simple to create. You just calculate each line item on the statement as a percentage of the total.
For example, each of the items on the income statement would be calculated as a percentage of total sales. (Divide each line item by total sales, then multiply each one by 100 to turn it into a percentage.) Similarly, items on the balance sheet would be calculated as percentages of total assets (or total liabilities plus owner's equity.)
This simple process converts numbers on your financial statements into information that you can use to make period-to-period and company-to-company comparisons. If you want to evaluate your cash position compared to the cash position of one of your key competitors, you need more information than what you have, say, $12,000 and he or she has $22,000. That's a lot less informative than knowing that your company's cash is equal to 7% of total assets, while your competitor's cash is 9% of their assets. Common size ratios make comparisons more meaningful; they provide a context for your data.
Common Size Ratios from the Balance Sheet
To calculate common size ratios from your balance sheet, simply compute every asset category as a percentage of total assets, and every liability account as a percentage of total liabilities plus owners' equity.
Here is what a common size balance sheet looks like for the mythical Doobie Company:
ABC Company Common Size Balance Sheet For the year ending December 31, 200x
Assets $$ % Current Assets Cash 12,000 6.6% Marketable Securities 10,000 5.5% Accounts Receivable (net of uncollectible accounts) 17,000 9.4% Inventory 22,000 12.2% Prepaid Expense 4,000 2.2% Total Current Assets 65,000 35.9% Fixed Assets Building and Equipment 105,000 58.3% Less Depreciation 30,000 16.6% Net Buildings and Equipment 75,000 41.6% Land 40,000 22.2% Total Fixed Assets 115,000 63.8% Total Assets 180,000 100.0% Liabilities Current Liabilities Wages Payable 3,000 1.6% Accounts Payable 25,000 13.8% Taxes Payable 12,000 6.6% Total Current Liabilities 40,000 22.2% Long-Term Liabilities Mortgage Payable 70,000 38.8% Note Payable 15,000 8.3% Deferred Taxes 15,000 8.3% Total Long-Term Liabilities 100,000 55.5% Total Liabilities 140,000 77.7% Owner's Equity 40,000 22.2% Total Liabilities and Owner's Equity 180,000 100.0%
In the example for Doobie Company, cash is shown as being 6.6% of total assets. This percentage is the result of the following calculation:
12,000/180,000 x 100
(Multiplying by 100 converts the ratio into a percentage.)
Common size ratios translate data from the balance sheet, such as the fact that there is $12,000 in cash, into the information that 6.6% of Doobie Company's total assets are in cash. Additional information can be developed by adding relevant percentages together, such as the realization that 11.7% (6.6% + 5.1%) of Doobie's total assets are in cash and marketable securities.
Common size ratios are a simple but powerful way to learn more about your business. This type of information should be computed and analyzed regularly.
As a small business owner, you should pay particular attention to trends in accounts receivables and current liabilities. Receivables should not be tying up an undue amount of company assets. If you see accounts receivables increasing dramatically over several periods, and it is not a planned increase, you need to take action. This might mean stepping up your collection practices, or putting tighter limits on the credit you extend to your customers.
As this example illustrates, the point of doing financial ratio analysis is not to collect statistics about your company, but to use those numbers to spot the trends that are affecting your company. Ask yourself why key ratios are up or down compared to prior periods or to your competitors. The answers to those questions can make an important contribution to your decision-making about the future of your company.
Current ratio analysis is also a very helpful way for you to evaluate how your company uses its cash.
Obviously it is vital to have enough cash to pay current liabilities, as your landlord and the electric company will tell you. The balance sheet for the Doobie Company shows that the company can meet current liabilities. The line items of "total current liabilities," $40,000, is substantially lower than "total current assets," $65,000.
But you may wonder, "How do I know if my current ratio is out of line for my type of business?" You can answer this question (and similar questions about any other ratio) by comparing your company with others. You may be able to convince competitors to share information with you, or perhaps a trade association for your industry publishes statistical information you can use. If not, you can use any of the various published compilations of financial ratios. (See the Resources section at the end of this document.)
Because financial ratio comparisons are so important for bank loan officers who make loans to businesses, RMA (formerly a bankers' trade association, Robert Morris Associates) has for many years published a volume called "Annual Statement Studies." These contain ratios for more than 300 industries, broken down by asset size and sales size. RMA's "Annual Statement Studies" are available in most public and academic libraries, or you may ask your banker to obtain the information you need.
Another source of information is "Industry Norms and Key Business Ratios," published by Dun and Bradstreet. It is compiled from D&B's vast databases of information on businesses. It lists financial ratios for hundreds of industries, and is available in academic and public libraries that serve business communities.
These and similar publications will give you an industry standard or "benchmark" you can use to compare your firm to others. The ratios described in this guide, and many others, are included in these publications. While period-to-period comparisons based on your own company's data are helpful, comparing your company's performance with other similar businesses can be even more informative.
Compute common size ratios using your company's balance sheet.
Common Size Ratios from the Income Statement
To prepare common size ratios from your income statement, simply calculate each income account as a percentage of sales. This converts the income statement into a powerful analytical tool.
Here is what a common size income statement looks like for the fictional Doobie Company:
$$ % Sales $ 200,000 100% Cost of goods sold 130,000 65% Gross Profit 70,000 35% Operating expenses Selling expenses 22,000 11% General e xpenses 10,000 5% Administrative expenses 4,000 2% Total operating expenses 36,000 18% Operating income 34,000 17% Other income 2,500 1% Interest expense 500 0% Income before taxes 36,000 18% Income taxes 1,800 1% Net profit 34,200 17%
Common size ratios allow you to make knowledgeable comparisons with past financial statements for your own company and to assess trends—both positive and negative—in your financial statements.
The gross profit margin and the net profit margin ratios are two common size ratios to which small business owners should pay particular attention. On a common size income statement, these margins appear as the line items "gross profit" and "net profit." For the Doobie Company, the common size ratios show that the gross profit margin is 35% of sales. This is computed by dividing gross profit by sales (and multiplying by 100 to create a percentage.)
$70,000/200,000 x 100 = 35%
Even small changes of 1% or 2% in the gross profit margin can affect a business severely. After all, if your profit margin drops from 5% of sales to 4%, that means your profits have declined by 20%.
Remember, your goal is to use the information provided by the common size ratios to start asking why changes have occurred, and what you should do in response. For example, if profit margins have declined unexpectedly, you probably will want to closely examine all expenses—again, using the common size ratios for expense line items to help you spot significant changes.
Compute common size ratios from your income statement.
Look at the gross profit and net profit margins as a percentage of sales. Compare these percentages with the same items from your income statement of a year ago. Are any fluctuations favorable or not? Do you know why they changed?
Liquidity ratios measure your company's ability to cover its expenses. The two most common liquidity ratios are the current ratio and the quick ratio . Both are based on balance sheet items.
Current Ratio
The current ratio is a reflection of financial strength. It is the number of times a company's current assets exceed its current liabilities, which is an indication of the solvency of that business.
Here is the formula to compute the current ratio.
Current Ratio = Total current assets/Total current liabilities
Using the earlier balance sheet data for the mythical Doobie Company, we can compute the company's current ratio.
Doobie Company Current Ratio:
65,000/40,000 = 1.6
This tells the owners of the Doobie Company that current liabilities are covered by current assets 1.6 times. The current ratio answers the question, "Does the business have enough current assets to meet the payment schedule of current liabilities, with a margin of safety?"
A common rule of thumb is that a "good" current ratio is 2 to 1. Of course, the adequacy of a current ratio will depend on the nature of the business and the character of the current assets and current liabilities. There is usually very little uncertainty about the amount of debts that are due, but there can be considerable doubt about the quality of accounts receivable or the cash value of inventory. That's why a safety margin is needed.
A current ratio can be improved by increasing current assets or by decreasing current liabilities. Steps to accomplish an improvement include:
A high current ratio may mean that cash is not being utilized in an optimal way. For example, the excess cash might be better invested in equipment.
Quick Ratio
The Quick Ratio is also called the "acid test" ratio. That's because the quick ratio looks only at a company's most liquid assets and compares them to current liabilities. The quick ratio tests whether a business can meet its obligations even if adverse conditions occur.
Here is the formula for the quick ratio:
Quick Ratio = (Current Assets − Inventory)/Current Liabilities
Assets considered to be "quick" assets include cash, stocks and bonds, and accounts receivable (in other words, all of the current assets on the balance sheet except inventory.)
Using the balance sheet data for the Doobie Company, we can compute the quick ratio for the company.
Quick ratio for the Doobie Company:
(65,000 − 22,000)/40,000 = 1.07
In general, quick ratios between 0.5 and 1 are considered satisfactory—as long as the collection of receivables is not expected to slow. So the Doobie Company seems to have an adequate quick ratio.
Compute a current ratio and a quick ratio using your company's balance sheet data.
There are many types of ratios that you can use to measure the efficiency of your company's operations. In this section we will look at four that are widely used. There may be others that are common to your industry, or that you will want to create for a specific purpose within your company.
The four ratios we will look at are:
Inventory Turnover
The inventory turnover ratio measures the number of times inventory "turned over" or was converted into sales during a time period. It is also known as the cost-of-sales to inventory ratio. It is a good indication of purchasing and production efficiency.
The data used to calculate this ratio come from both the company's income statement and balance sheet. Here is the formula:
Inventory Ratio = Cost of Goods Sold/Inventory
Using the financial statements for the Doobie Company, we can compute the following inventory turnover ratio for the company:
$130,000/22,000 = 5.91
In general, the higher a cost of sales to inventory ratio, the better. A high ratio shows that inventory is turning over quickly and that little unused inventory is being stored.
Sales-to-Receivables Ratio
The sales-to-receivables ratio measures the number of times accounts receivables turned over during the period. The higher the turnover of receivables, the shorter the time between making sales and collecting cash. The ratio is based on NET sales and NET receivables. (A reminder: net sales equals sales less any allowances for returns or discounts. Net receivables equals accounts receivable less any adjustments for bad debts.)
This ratio also uses information from both the balance sheet and the income statement. It is calculated as follows:
Sales-to-Receivables Ratio = Net Sales/Net Receivables
Using the financial statements for the Doobie Company (and assuming that the Sales reported on their income statement is net Sales), we can compute the following sales- to-receivables ratio for the company:
Doobie Company Sales-to-Receivables Ratio:
200,000/17,000 = 11.76
This means that receivables turned over nearly 12 times during the year. This is a ratio that you will definitely want to compare to industry standards. Keep in mind that its significance depends on the amount of cash sales a company has. For a company without many cash sales, it may not be important. Also, it is a measure at only one point in time and does not take into account seasonal fluctuations.
Days' Receivables Ratio
The days' receivables ratio measures how long accounts receivable are outstanding. Business owners will want as low a days' receivables ratio as possible. After all, you want to use your cash to build your company, not to finance your customers. Also, the likelihood of nonpayment typically increases as time passes.
It is computed using the sales/receivables ratio. Here is the formula:
Days' Receivables Ratio = 365/Sales Receivables Ratio
The "365" in the formula is simply the number of days in the year. The sales receivable ratio is taken from the calculation we did just a few paragraphs earlier.
Using the financial statements for the Doobie Company, we can compute the following day's receivables ratio for the company.
Doobie Company Days' Receivables Ratio
365/11.76 = 31
This means that receivables are outstanding an average of 31 days. Again, the real meaning of the number will only be clear if you compare your ratios to others in the industry.
Debt-to-Worth Ratio = Total Liabilities/Net Worth
Doobie Company debt-to-worth ratio: $140,000/40,000 = 3.5
Working Capital = Total Current Assets − Total Current Liabilities
Using the balance sheet data for the Doobie Company, we can compute the working capital amount for the company.
Doobie Company working capital: $65,000 − 40,000 = $25,000 Doobie Company has $25,000 in working capital
Net Sales to Working Capital The relationship between net sales and working capital is a measurement of the efficiency in the way working capital is being used by the business. It shows how working capital is supporting sales. It is computed as follows:
Net Sales to Working Capital Ratio = Net Sales/Net Working Capital
Using balance sheet data for the Doobie Company and the working capital amount computed in the previous calculation, we compute the net sales to working capital as follows:
Doobie Company Net Sales to Working Capital Ratio $200,000/25,000 = 8
Again, this is a ratio that must be compared to others in your industry to be meaningful. In general, a low ratio may indicate an inefficient use of working capital; that is, you could be doing more with your resources, such as investing in equipment. A high ratio can be dangerous, since a drop in sales which causes a serious cash shortage could leave your company vulnerable to creditors.
The Z-Score is at the end of our list neither because it is the least important, nor because it's at the end of the alphabet. It's here because it's a bit more complicated to calculate. In return for doing a little more arithmetic, however, you get a number—a Z-Score—which most experts regard as a very accurate guide to your company's financial solvency. In blunt terms, a Z-Score of 1.81 or below means you are headed for bankruptcy. One of 2.99 means your company is sound.
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