Effects of Theory of Ratio Analysis in an Organisation

Introduction

Ratio, in general, shows a proportional relationship between two different numbers or quantities. It may be a relationship between two amounts that is represented by a pair of numbers showing how much greater one amount is than the other, that is, the ratio of something to something. When undertaken by a business management in the process of Financial Analysis in order to identify the financial strengths and weaknesses of a business entity by establishing the relationship between the balance sheet’s and the income statement’s items, ratios play an important role being used as yardstick for evaluating the Financial position as well as the performance of a business entity. The relationship between two accounting figures, expressed mathematically, is known as a financial ratio.

Effective planning and Financial Management are the keys to running a financially successful business. Ratio analysis is a useful management tool that assists in effective planning and running a financially successful business. Ratios, on the one hand, help greatly in summarizing the large amount of financial data by making the interpretation of financial statements easier; they enable to make qualitative judgment about a business firm’s financial performance on the other. It’s through the ratio analysis that the liquidity, solvency, profitability and the activity of a business entity may be identified in an accurate manner.

Ratio Analysis is a powerful tool of Financial Analysis. Having simplified the understanding of Financial Statements, ratios reveal the inter relationship between various financial figures which in turn enables analyst to gain insights in making forward-looking and projections accordingly. Though the ratio analysis is made on the basis of the accounting data which is historical in nature, but the study of trends can also facilitate in effective planning and controlling and forecasting. Besides, establishing a relationship between two figures and adding significance, ratios facilitate to make comparisons between a firm’s past and present performance, while they also aid greatly in comparing one business firm with another.

As pointed out above, Ratios are calculated on the basis of accounting data that in turn may be classified in a number of ways. They provide what is wanted or needed in a particular situation or by a particular group of people depending upon their interests in business. The information about the liquidity position, that is, the ability of a business to meet its current obligations, is needed by short term creditors, whereas the long term creditors are interested to know the solvency position of a business. As regards the performance of a business, the management needs to evaluate all the aspects of a business that are helpful in identifying the activities as well as the performance of a business entity.

It’s true that the ratios are just supplementary to the absolute figures taken from the Income statement and the balance sheet, but they reveal absolutely true story of a business entity that is not to be directly expressed in the absence of Ratio Analysis. Thus, the ratio analysis plays a significant role in the process of Financial Analysis through which a business is enabled to find good prospects and perform better while it’s also facilitated for ranking management’s ability.

What is 'Ratio Analysis'

A ratio analysis is a quantitative analysis of information contained in a company’s financial statements. Ratio analysis is used to evaluate various aspects of a company’s operating and financial performance such as its efficiency, liquidity, profitability and solvency.

Financial ratio analysis is performed by comparing two items in the financial statements. The resulting ratio can be interpreted in a way that is not possible when interpreting the items separately.

Ratio Analysis is a form of Financial Statement Analysis that is used to obtain a quick indication of a firm's financial performance in several key areas. The ratios are categorized as Short-term Solvency Ratios, Debt Management Ratios, Asset Management Ratios, Profitability Ratios, and Market Value Ratios.

Ratio Analysis as a tool possesses several important features. The data, which are provided by financial statements, are readily available. The computation of ratios facilitates the comparison of firms which differ in size. Ratios can be used to compare a firm's financial performance with industry averages. In addition, ratios can be used in a form of trend analysis to identify areas where performance has improved or deteriorated over time.

Because Ratio Analysis is based upon Accounting information, its effectiveness is limited by the distortions which arise in financial statements due to such things as Historical Cost Accounting and inflation. Therefore, Ratio Analysis should only be used as a first step in financial analysis, to obtain a quick indication of a firm's performance and to identify areas which need to be investigated further.

Types of Financial Ratios

Here is a list of various financial ratios. Take note that most of the ratios can also be expressed in percentage by multiplying the decimal number by 100%. Each ratio is briefly described.

Profitability Ratios

Gross Profit Rate = Gross Profit ÷ Net Sales

Evaluates how much gross profit is generated from sales. Gross profit is equal to net sales (sales minus sales returns, discounts, and allowances) minus cost of sales.

Return on Sales = Net Income ÷ Net Sales

Also known as "net profit margin" or "net profit rate", it measures the percentage of income derived from dollar sales. Generally, the higher the ROS the better.

Return on Assets = Net Income ÷ Average Total Assets

In financial analysis, it is the measure of the return on investment. ROA is used in evaluating management's efficiency in using assets to generate income.

Return on Stockholders' Equity = Net Income ÷ Average Stockholders' Equity

Measures the percentage of income derived for every dollar of owners' equity.

Liquidity Ratios

Current Ratio = Current Assets ÷ Current Liabilities

Evaluates the ability of a company to pay short-term obligations using current assets (cash, marketable securities, current receivables, inventory, and prepayments).

Acid Test Ratio = Quick Assets ÷ Current Liabilities

Also known as "quick ratio", it measures the ability of a company to pay short-term obligations using the more liquid types of current assets or "quick assets" (cash, marketable securities, and current receivables).

Cash Ratio = ( Cash + Marketable Securities ) ÷ Current Liabilities

Measures the ability of a company to pay its current liabilities using cash and marketable securities. Marketable securities are short-term debt instruments that are as good as cash.

Net Working Capital = Current Assets - Current Liabilities

Determines if a company can meet its current obligations with its current assets; and how much excess or deficiency there is.

Management Efficiency Ratios

Receivable Turnover = Net Credit Sales ÷ Average Accounts Receivable

Measures the efficiency of extending credit and collecting the same. It indicates the average number of times in a year a company collects its open accounts. A high ratio implies efficient credit and collection process.

Days Sales Outstanding = 360 Days ÷ Receivable Turnover

Also known as "receivable turnover in days", "collection period". It measures the average number of days it takes a company to collect a receivable. The shorter the DSO, the better. Take note that some use 365 days instead of 360.

Inventory Turnover = Cost of Sales ÷ Average Inventory

Represents the number of times inventory is sold and replaced. Take note that some authors use Sales in lieu of Cost of Sales in the above formula. A high ratio indicates that the company is efficient in managing its inventories.

Days Inventory Outstanding = 360 Days ÷ Inventory Turnover

Also known as "inventory turnover in days". It represents the number of days inventory sits in the warehouse. In other words, it measures the number of days from purchase of inventory to the sale of the same. Like DSO, the shorter the DIO the better.

Accounts Payable Turnover = Net Credit Purchases ÷ Ave. Accounts Payable

Represents the number of times a company pays its accounts payable during a period. A low ratio is favored because it is better to delay payments as much as possible so that the money can be used for more productive purposes.

Days Payable Outstanding = 360 Days ÷ Accounts Payable Turnover

Also known as "accounts payable turnover in days", "payment period". It measures the average number of days spent before paying obligations to suppliers. Unlike DSO and DIO, the longer the DPO the better (as explained above).

Operating Cycle = Days Inventory Outstanding + Days Sales Outstanding

Measures the number of days a company makes 1 complete operating cycle, i.e. purchase merchandise, sell them, and collect the amount due. A shorter operating cycle means that the company generates sales and collects cash faster.

Cash Conversion Cycle = Operating Cycle - Days Payable Outstanding

CCC measures how fast a company converts cash into more cash. It represents the number of days a company pays for purchases, sells them, and collects the amount due. Generally, like operating cycle, the shorter the CCC the better.

Total Asset Turnover = Net Sales ÷ Average Total Assets

Measures overall efficiency of a company in generating sales using its assets. The formula is similar to ROA, except that net sales is used instead of net income.

Leverage Ratios

Debt Ratio = Total Liabilities ÷ Total Assets

Measures the portion of company assets that is financed by debt (obligations to third parties). Debt ratio can also be computed using the formula: 1 minus Equity Ratio.

Equity Ratio = Total Equity ÷ Total Assets

Determines the portion of total assets provided by equity (i.e. owners' contributions and the company's accumulated profits). Equity ratio can also be computed using the formula: 1 minus Debt Ratio.

The reciprocal of equity ratio is known as equity multiplier, which is equal to total assets divided by total equity.

Debt-Equity Ratio = Total Liabilities ÷ Total Equity

Evaluates the capital structure of a company. A D/E ratio of more than 1 implies that the company is a leveraged firm; less than 1 implies that it is a conservative one.

Times Interest Earned = EBIT ÷ Interest Expense

Measures the number of times interest expense is converted to income, and if the company can pay its interest expense using the profits generated. EBIT is earnings before interest and taxes.

Valuation and Growth Ratios

Earnings per Share = ( Net Income - Preferred Dividends ) ÷ Average Common Shares Outstanding

EPS shows the rate of earnings per share of common stock. Preferred dividends is deducted from net income to get the earnings available to common stockholders.

Price-Earnings Ratio = Market Price per Share ÷ Earnings per Share

Used to evaluate if a stock is over- or under-priced. A relatively low P/E ratio could indicate that the company is under-priced. Conversely, investors expect high growth rate from companies with high P/E ratio.

Dividend Pay-out Ratio = Dividend per Share ÷ Earnings per Share

Determines the portion of net income that is distributed to owners. Not all income is distributed since a significant portion is retained for the next year's operations.

Dividend Yield Ratio = Dividend per Share ÷ Market Price per Share

Measures the percentage of return through dividends when compared to the price paid for the stock. A high yield is attractive to investors who are after dividends rather than long-term capital appreciation.

Book Value per Share = Common SHE ÷ Average Common Shares

Indicates the value of stock based on historical cost. The value of common shareholders' equity in the books of the company is divided by the average common shares outstanding.

Using Ratio Analysis

We need to be aware of what ratio analysis can do and what it can not do. Ratio analysis requires a "base" against which to compare each ratio. We often compare a firm’s ratios to past measures of the same ratios in the firm. This is called trend analysis and allows us to analyze any general movements in the firm’s financial situation by looking for patterns in the ratios over time. Trend analysis adds a dynamic aspect to the analysis and provides consistency because each year’s numbers are from the same firm.

 Another common basis of comparison is to look at how a firm’s ratios compare to similar firms in the industry. This can highlight a firm’s strengths and weaknesses relative to the other firms in the industry. Major sources of industry and comparative ratios include: Dun and Bradstreet, a publication of Dun and Bradstreet, Inc.; Robert Morris Associates, an association of loan officers; financial and investor services such as the Standard and Poor’s survey; government agencies such as the FTC, SEC, and Department of Commerce; trade associations; business periodicals; corporate reports; and other miscellaneous sources such as books and accounting firms.

While ratio analysis can be a powerful and useful tool, it does suffer from a number of weaknesses. It is important to be aware of and understand accounting practices over time and/or across firms.

Difficult problems arise when making comparisons across firms in an industry. The comparison must be made over the same time periods. In addition, firms within an "industry" often differ substantially in the structure and type of business, making industry comparisons less meaningful. Another difficulty is that a departure from the "norm" may not indicate a problem. As mentioned before, a firm might have apparent weaknesses in one area that are offset by strengths in other areas. Furthermore, things like different production practices in a firm may require a different financial structure than other firms in the industry. Additionally, shooting for financial ratios that look like the industry average may not be very desirable. Would you want your business to be average?

It was mentioned earlier that inflation can have a significant impact on a firm’s balance sheet and consequently inflation will impact a firm’s corresponding financial ratios. It is important to keep in mind the book value nature of financial statements. Firms that keep a set of market value financial statements in addition to their book value financial statements should conduct financial analysis with both their book value and market value financial statements. It is also important to recognize that a single ratio does not provide adequate information to evaluate the strength or weakness of a firm. A weak ratio in one area might be offset by a strong ratio in another area. Likewise, a perfectly healthy firm, from a financial standpoint, may have some special characteristics which result in a ratio which would be out of line for other firms in the industry who do not have these characteristics. Finally, it must be understood that financial analysis does not make management decisions. The analysis provides information which will be a valuable input into making management decisions but there is no "cook book" formula that you plug the financial analysis number into and produce the correct management decisions.

Limitations of Financial Ratios


There are some important limitations of financial ratios that analysts should be conscious of:

• Many large firms operate different divisions in different industries. For these companies it is difficult to find a meaningful set of industry-average ratios.
• Inflation may have badly distorted a company's balance sheet. In this case, profits will also be affected. Thus a ratio analysis of one company over time or a comparative analysis of companies of different ages must be interpreted with judgment.
• Seasonal factors can also distort ratio analysis. Understanding seasonal factors that affect a business can reduce the chance of misinterpretation. For example, a retailer's inventory may be high in the summer in preparation for the back-to-school season. As a result, the company's accounts payable will be high and its ROA low.
• Different accounting practices can distort comparisons even within the same company (leasing versus buying equipment, LIFO versus FIFO, etc.).
• It is difficult to generalize about whether a ratio is good or not. A high cash ratio in a historically classified growth company may be interpreted as a good sign, but could also be seen as a sign that the company is no longer a growth company and should command lower valuations.
• A company may have some good and some bad ratios, making it difficult to tell if it's a good or weak company.

In general, ratio analysis conducted in a mechanical, unthinking manner is dangerous. On the other hand, if used intelligently, ratio analysis can provide insightful information.

Conclusion

Ratio analysis can provide an early warning of a potential improvement or deterioration in a company’s financial situation or performance. Analysts engage in extensive number-crunching of the financial data in a company’s quarterly financial reports for any such hints. Successful companies generally have solid ratios in all areas, and any hints of weakness in one area may spark a significant sell-off in the stock. Certain ratios are closely scrutinized because of their relevance to a certain sector, as for instance inventory turnover for the retail sector and days sales outstanding (DSOs) for technology companies.  

Of course, using any ratio in any of the categories listed above should only be considered as a starting point. Further ratio analysis using more ratios and using qualitative analysis should be incorporated to effectively analyze a company's financial position.

Ratios are usually only comparable across companies in the same sector, since an acceptable ratio in one industry may be regarded as too high in another. For example, companies in sectors such as utilities typically have a high debt-equity ratio, but a similar ratio for a technology company may be regarded as unsustainably high.