financial statement ratio analysis

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Financial Analysis

When you are analyzing a financial statement, it is best to reduce amount comparisonsto percentages or ratios so that you have an easy way to judge those comparisons. Andif you compare those ratio results with what you know to be good, fair

Importance or necessary of financial statement: The information given in thefinancial statement is very useful to a number of parties. These are thefollowings:

1. Owners : The owners provide fund for the operation of a business and they want toknow whether their funds are beings properly utilized or not.

2. Creditors : Creditors want to know the financial position of business concernbefore giving loans or granting credits. The financial statements help them in

judging such position.3. Investors : Prospective inspectors who want to invest money in firm would like to

make an analysis of financial statements of them firm to know how sale thepropose investment will be.

4. Employee : Employee are interested are in the financial position of a businessconcern they serve particularly when the payment of bonus depends upon theprofit earned.

5. Government : Center and state government are interested in the financialstatement because they reflect the earning for particular period for this period.

6. Consumers : Consumers are interested in the establishment of good accountingcontour so that the cost of production may be reduced with the resultantreduction of the price of goods they buy.

Limitations of financial statement:a. Internal and not final report.b. Lack of pricing and definiteness.c. Lack of objective judgment.

d. Historical nature.e. Artificial view.f. Scope of manipulation.g. Inadequate information.

Ratios to Determine Strength & Weaknesses

Everyone in the business of analyzing financial statements has a few favorite ratiosthey utilize when determining the strengths or weaknesses of a specific financialstatement. The ratios that are used could change depending upon the industry thebusiness is in, the size of the business, the accounting the accounting method that isused by the business and the amount of the credit desired and how healthy thecompany is.

Ratio

Types of Ratios

Liquidity Ratios

Asset management/Activity ratios

Financial Leverage/Gearing ratios

Profitability ratios

Market valuation ratios

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Ratio limitations

A ratio: Is the mathematical relationship between two quantities in the form of afraction or percentage.Ratio analysis: is essentially concerned with the calculation of relationships whichafter proper identification and interpretation may provide information about the

operations and state of affairs of a business enterprise.

The analysis is used to provide indicators of past performance in terms of criticalsuccess factors of a business. This assistance in decision-making reduces reliance onguesswork and intuition and establishes a basis for sound judgment.

Consider a current ratio of 2:1. This means that for every 1 monetary value of currentliabilities there are 2 of assets. However each business is different and each hasdifferent working capital requirements. From this ratio, we cannot make anycomments about the liquidity of the business, whether it carries too much or too littleworking capital.

Significance of Using Ratios

The significance of a ratio can only truly be appreciated when:

1. It is compared with other ratios in the same set of financial statements.2. It is compared with the same ratio in previous financial statements (trend

analysis).3. It is compared with a standard of performance (industry average). Such a

standard may be either the ratio which represents the typical performance ofthe trade or industry, or the ratio which represents the target set bymanagement as desirable for the business.

Types of RatiosNote that throughout this section, ratios are derived from Exhibit one in Session 1 ofthis chapter

A: Liquidity Ratios

Liquidity refers to the ability of a firm to meet its short-term financial

obligations when and as they fall due.

The main concern of liquidity ratio is to measure the ability of the firms to

meet their short-term maturing obligations. Failure to do this will result in thetotal failure of the business, as it would be forced into liquidation.

Current RatioThe Current Ratio expresses the relationship between the firms current assets andits current liabilities.Current assets normally includes cash, marketable securities, accounts receivableand inventories. Current liabilities consist of accounts payable, short term notespayable, short-term loans, current maturities of long term debt, accrued incometaxes and other accrued expenses (wages).

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The rule of thumb says that the current ratio should be at least 2, that is the current assetsshould meet current liabilities at least twice.What does the calculated ratio tells us? In 2000, the company only had 85 cents worth ofcurrent assets for every dollar of liabilities. This grew to 92 cents in 2002 indicating increasingtrend on liquidity, however the company is still unable to support its short-term debt from itscurrents assets.

Quick Ratio: Measures assets that are quickly converted into cash and they are comparedwith current liabilities. This ratio realizes that some of current assets are not easily convertibleto cash e.g. inventories.

The quick ratio, also referred to as acid test ratio, examines the ability of the business to coverits short-term obligations from its quick assets only (i.e. it ignores stock). The quick ratio iscalculated as follows

Clearly this ratio will be lower than the current ratio, but the difference between the two (thegap) will indicate the extent to which current assets consist of stock.

Average Collection PeriodThe average collection period measures the quality of debtors since it indicates thespeed of their collection.

The shorter the average collection period, the better the quality of debtors, as

a short collection period implies the prompt payment by debtors. The average collection period should be compared against the firms credit

terms and policy to judge its credit and collection efficiency.

An excessively long collection period implies a very liberal and inefficient

credit and collection performance.

The delay in collection of cash impairs the firms liquidity. On the other hand,

too low a collection period is not necessarily favourable, rather it may indicatea very restrictive credit and collection policy which may curtail sales andhence adversely affect profit.

Inventory TurnoverThis ratio measures the stock in relation to turnover in order to determine how oftenthe stock turns over in the business.

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It indicates the efficiency of the firm in selling its product. It is calculated by dividinghe cost of goods sold by the average inventory.

The ratio shows a relatively high stock turnover which would seem to suggest thatthe business deals in fast moving consumer goods.

The company turned over stock every 24 days in 2000 and every 28 days in

2002.

The trend shows a marginal increase in days which indicates a slow down of stockturnover.

The high stock turnover ratio would also tend to indicate that there was little

chance of the firm holding damaged or obsolete stock.

Total Assets TurnoverAsset turnover is the relationship between sales and assets

The firm should manage its assets efficiently to maximise sales.

The total asset turnover indicates the efficiency with which the firm uses all its

assets to generate sales.

It is calculated by dividing the firms sales by its total assets.

Generally, the higher the firms total asset turnover, the more efficiently its

assets have been utilised.

Fixed Asset TurnoverThe fixed assets turnover ratio measures the efficiency with which the firm has beenusing its fixed assets to generate sales.It is calculated by dividing the firms sales by its net fixed assets as follows:

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Generally, high fixed assets turnovers are preferred since they indicate a

better efficiency in fixed assets utilisation.

From the above calculations:

It appears that the activity of the business is relatively constant, with a slight

upward trend.

The ratio also confirms that the business places a much greater reliance on

working capital than it does on the fixed assets as the fixed assets (2001 and2002) turned over more quicker than stock turnover.

C: Financial Leverage (Gearing) Ratios

The ratios indicate the degree to which the activities of a firm are supported

by creditors funds as opposed to owners.

The relationship of owners equity to borrowed funds is an important indicator

of financial strength.

The debt requires fixed interest payments and repayment of the loan and

legal action can be taken if any amounts due are not paid at the appointedtime. A relatively high proportion of funds contributed by the owners indicates

a cushion (surplus) which shields creditors against possible losses from defaultin payment.Note: The greater the proportion of equity funds, the greater the degree offinancial strength. Financial leverage will be to the advantage of the ordinaryshareholders as long as the rate of earnings on capital employed is greaterthan the rate payable on borrowed funds.

The following ratios can be used to identify the financial strength and risk of

the business.

Equity RatioThe equity ratio is calculated as follows:

This indicates that only 32.1% of the total assets in 2002 is supplied by the ordinarystockholders and this has shown a slight decrease from 32.8% in 2000.

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A high equity ratio reflects a strong financial structure of the company. A

relatively low equity ratio reflects a more speculative situation because of theeffect of high leverage and the greater possibility of financial difficulty arisingfrom excessive debt burden.

Debt Ratio

This is the measure of financial strength that reflects the proportion of capital whichhas been funded by debt, including preference shares.

This ratio is calculated as follows:

With higher debt ratio (low equity ratio), a very small cushion has developed thus notgiving creditors the security they require. The company would therefore find itrelatively difficult to raise additional financial support from external sources if itwished to take that route. The higher the debt ratio the more difficult it becomes forthe firm to raise debt.

Debt to Equity ratioThis ratio indicates the extent to which debt is covered by shareholders funds. Itreflects the relative position of the equity holders and the lenders and indicates thecompanys policy on the mix of capital funds. The debt to equity ratio is calculated asfollows:

The debt to equity ratio shows that for every 1 dollar of shareholders funds in

2002 there was 2.12 dollars of debt. This compares to 2.05 dollars in 2000.This ratio is extremely high and indicates the financial weakness of thebusiness.

Times Interest Earned RatioThis ratio measure the extent to which earnings can decline without causing financiallosses to the firm and creating an inability to meet the interest cost.

The times interest earned shows how many times the business can pay its

interest bills from profit earned.

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Present and prospective loan creditors such as bondholders, are vitally

interested to know how adequate the interest payments on their loans arecovered by the earnings available for such payments.

Owners, managers and directors are also interested in the ability of the

business to service the fixed interest charges on outstanding debt.

The ratio is calculated as follows:

The companys major forms of credit are non-interest bearing (trade creditors)

which results in the business enjoying very healthy interest coverage rates. In2002 the company could pay their interest bill 16.5 times from earningsbefore interest and tax. However this is a massive drop from 51.5 times in

2001 and 37.7 times in 2000.

D: Profitability RatiosProfitability is the ability of a business to earn profit over a period of time. Althoughthe profit figure is the starting point for any calculation of cash flow, as alreadypointed out, profitable companies can still fail for a lack of cash.

Note: Without profit, there is no cash and therefore profitability must be seen as acritical success factors.

A company should earn profits to survive and grow over a long period of time.

Profits are essential, but it would be wrong to assume that every action

initiated by management of a company should be aimed at maximizingprofits, irrespective of social consequences.

The ratios examined previously have tendered to measure management efficiencyand risk.

Profitability is a result of a larger number of policies and decisions. The profitabilityratios show the combined effects of liquidity, asset management (activity) and debtmanagement (gearing) on operating results. The overall measure of success of abusiness is the profitability which results from the effective use of its resources.

Gross Profit Margin

Normally the gross profit has to rise proportionately with sales.

It can also be useful to compare the gross profit margin across similar

businesses although there will often be good reasons for any disparity.

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The ratio above shows the increasing trend in the gross profit since the ratiohas improved from 15.2% in 2000 to 20.3% on 2002. This indicates that therate in increase in cost of goods sold are less than rate of increase in sales,hence the increased efficiency.

Net Profit MarginThis is a widely used measure of performance and is comparable across companies insimilar industries. The fact that a business works on a very low margin need notcause alarm because there are some sectors in the industry that work on a basis ofhigh turnover and low margins, for examples supermarkets and motorcar dealers.What is more important in any trend is the margin and whether it compares well withsimilar businesses.

The net margin ratio shows that the margin is fairly stable over time with slightimprovement to 1.73% in 2001. However, to know how well the firm is performingone has to compare this ratio with the industry average or a firm dealing in a similarbusiness.

Return on Investment (ROI)

Income is earned by using the assets of a business productively. The more efficientthe production, the more profitable the business. The rate of return on total assetsindicates the degree of efficiency with which management has used the assets of theenterprise during an accounting period. This is an important ratio for all readers offinancial statements.

Investors have placed funds with the managers of the business. The managers usedthe funds to purchase assets which will be used to generate returns. If the return isnot better than the investors can achieve elsewhere, they will instruct the managersto sell the assets and they will invest elsewhere. The managers lose their jobs andthe business liquidates.

The ratio indicates that there is increase in the ROI from 8.38% in 2000 to 8.95% in2002.

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Return on Equity (ROE)This ratio shows the profit attributable to the amount invested by the owners of thebusiness. It also shows potential investors into the business what they might hope toreceive as a return. The stockholders equity includes share capital, share premium,distributable and non-distributable reserves. The ratio is calculated as follows:

Again, the profitability to ordinary shareholders is strong and showing an upwardtrend. Note that the return in 2002 as in all the years is after tax and theshareholders should be extremely comfortable with these returns.

Earning Per Share (EPS)Whatever income remains in the business after all prior claims, other than ownersclaims (i.e. ordinary dividends) have been paid, will belong to the ordinary

shareholders who can then make a decision as to how much of this income they wishto remove from the business in the form of a dividend, and how much they wish toretain in the business. The shareholders are particularly interested in knowing howmuch has been earned during the financial year on each of the shares held by them.For this reason, an earning per share figure must be calculated Clearly then, theearning per share calculation will be:

E: Market Value RatiosThese ratios indicate the relationship of the firms share price to dividends andearnings. Note that when we refer to the share price, we are talking about the Marketvalue and not the Nominal value as indicated by the par value.

For this reason, it is difficult to perform these ratios on unlisted companies as themarket price for their shares is not freely available. One would first have to value theshares of the business before calculating the ratios. Market value ratios are strongindicators of what investors think of the firms past performance and futureprospects.

Dividend Yield RatioThe dividend yield ratio indicates the return that investors are obtaining on theirinvestment in the form of dividends. This yield is usually fairly low as the investorsare also receiving capital growth on their investment in the form of an increasedshare price. It is interesting to note that there is strong correlation between dividendyields and market prices. Invariably, the higher the dividend, the higher the marketvalue of the share. The dividend yield ratio compares the dividend per share againstthe price of the share and is calculated as:

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Notice a healthy increase in the yield from 2000 to 2002. The main reason for this isthat the dividend per share increased while at the same time, the price of a sharedropped.

This is fairly unusual because share prices usually increase when dividends increase.However there could be number of reasons why this has happened, either due to theeconomy or to mismanagement, leading to a loss of faith in the stock market or inthis particular stock.

Normally a very high dividend yield signals potential financial difficulties and possibledividend payout cut. The dividend per share is merely the total dividend divided bythe number of shares issued. The price per share is the market price of the share atthe end of the financial year.

Price/Earning Ratio (P/E ratio)

P/E ratio is a useful indicator of what premium or discount investors are

prepared to pay or receive for the investment.

The higher the price in relation to earnings, the higher the P/E ratio which

indicates the higher the premium an investor is prepared to pay for the share.This occurs because the investor is extremely confident of the potentialgrowth and earnings of the share.

The price-earning ratio is calculated as follows:

1. High P/E generally reflects lower risk and/or higher growth prospects forearnings.

2. The above ratio shows that the shares were traded at a much higher premiumin 2000 than were in 2002. In 2000 the price was 26.8 times higher thanearnings while in 2002, the price was only 12 times higher.

Dividend Cover

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This ratio measures the extent of earnings that are being paid out in the form

of dividends, i.e. how many times the dividends paid are covered by earnings(similar to times interest earned ratio discussed above).

A higher cover would indicate that a larger percentage of earnings are being

retained and re-invested in the business while a lower dividend cover wouldindicate the converse.

Dividend pay-out ratioThis ratio looks at the dividend payment in relation to net income and can becalculated as follows:

Note: Even though the dividend yield has increased, the dividend payout ratio hasreduced, showing that a lower proportion of earnings was paid out as dividend. Theratio has only reduced slightly, however, from 50.7% in 2000 to 49.4% in 2002.Generally, the low growth companies have higher dividends payouts and high growthcompanies have lower dividend payouts.

Relationship Among Ratios

Summary of Financial Ratios & Their Meaning

1. Profitability Ratios

Ratios Formula Meaning Desired Trend

a. ContributionMargin tosales

Contribution Margin*1000 / Sales

Measures the margin ofprofitability on sales throughoutthe trading year and will varyfrom industry to industry. Thepercentage should be relativelyconstant and any changesinvestigated. Reasons forchanges could be reducedselling price or increase in thecost of sales.

The higher the ratiothe higher the cutreceived on eachsales

b. COGS tosales

COGS x1000/ NetSales

The % of COGS relative to sales.Helps measure the relative costsof inputs.

The lower the ratio,the lower the costs.

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c. Operatingexpenses tosales

Operating Expensesx100/ Net sales

The % if any operating expensesrelative to sales. Measures therelative impact of operatingexpenses.

The lower the ratio,the lower theexpense relative tosales.

d. Net incometo sales

Net income x 100/Net Sales

% of net income earned forevery sales Taka. Measuresultimate profitability.

The higher the ratiothe more profitableeach sale.

2. Return on Investment:

Ratio Formula Meaning Desired Trend

a. Return on Assets(ROA).

Net Income/ Average TotalAssets( May also use EBITinstead of net income)

Shows therelationships betweenincome & total assets.

High return = Gooduse of assets.

b. Return on Equity(ROE)

Net Income/ AverageShareholders Equity

Shows the maximumreturn available to

shareholders.

High return = Happyshareholders/owner

.

3. Investment / Assets UtilizationRatio Formula Meaning Desired Trend

Asset Turnover Net Sales / Net Assets Shows how fully thecompany is using itscapital and how manypounds of turnover isgenerated by each poundof investment.Helps measure theusefulness of the assets.

Higher is better;Too low- useless assbut

Too high-perhaps noenough assets may forgoing opportuniti

InventoryTurnover COGS / AverageInventory How many times a year isthe inventory being sold?Measures the speed atwhich the inventorycomes in & goes out.Or, Measures liquidity ofinventory.

Higher is better;Too low- the inventositting around to lon(Obsolescence) but

Too high-may not haenough inventory tomeet demand (stockouts)

Fixed AssetsTurnover

Net Sales / AverageNet Fixed Assets

How many sales dollarsare earned for everydollar of fixed assets?Helps measure how usefulthe fixed assets are to thebusiness.

Higher is better;Too low- may haveuseless assets that cbe sold. but

Too high-may sign tare old & needreplacing.

4. Liquidity Ratio:

Ratios Formula Meaning Desired Trenda.Current Ratio Current Assets / Current

LiabilitiesThe number of timesthat short-term assetscan cover short-termdebts. It indicates an

Higher to a point(2:1 rule of thumb)

Too low-may lead toinsolvency but too

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ability to meet shortterm obligations asthey come due.

high-inefficient useof capital ( sincecurrent assetsgenerally have thelowest return)

Liquidity Ratio

or Acid Test

Current Assets minus

Stock / Current Liabilities

Indicates the ability to

meet short termpayments, using onlythe most liquid ofassets.

Higher to a point

(1:1 rule of thumb)

Working Capital Current Assets - CurrentLiabilities.

The net amount ofmoney tied up inworking capital.

Higher is safer butworking capital has low return; if toohigh, moneys betterspent elsewhere.

Age ofReceivableOrAverage

CollectionPeriod.

Account Receivable/Average daily sales.

Average Daily sales =

Total Sales/365

How old (in days) isthe averageoutstanding balanceon credit sales.

Should be closed tothe industry average(Preferably on thelower end)

If too low- may bethe credit policiesare too tight & arescaring off business

5. Solvency Ratios/ Stability RatiosRatios Formula Meaning Desired trend

a. Total Debt tototal assets ratio

Total liabilities/ TotalEquity

What percentage ofthe business isfinanced through debt.OrMeasures the % of thetotal assets provided

by creditors.

Lower is safer

b. Debt toEquity

Total liabilities/ TotalAssets

The number of timesof debt for everydollar of equity.

Lower is safer.To high-to highlyleveraged(either toomuch debt or toosmall an equitybase.)

c. Net worth toTotal Assets

Total Equity/ Total Assets What percentage ofthe business is ownedby equity?

Higher is safer.Too low- too muchdebt but Too highlikely underleveraged therebyreducing ROE. Also

debt is cheaper thanequity, use it ifpossible.

d. Time interestearnedorLong-term DebtinterestCoverage

EBIT/ Interest on longterm debt.

The number of timesover that a companycan meet its interestpayments.

Lenders needassurance that theirloan charges(interest) can becovered.

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