You can analyze a company’s financial statements using a variety of analytical methods. One of these methods is Ratio Analysis. It plays a vital role in financial statement analysis.
Ratio analysis presents the data facts of financial statements in a comparative way. It provides an efficient means by which a decision-maker can identify important relationships between items in the same statements.
Ratios are calculated in order to reduce the financial data to a more understandable basis for the evaluation of the financial condition and past financial performance of the entity.
In the mathematical term, a ratio is a relationship between two numbers indicating how many times the first number contains the second.
For example, if a company has current assets of Rs. 800000 and current liabilities of Rs. 400000 then the ratio of currents assets to current liabilities is eight lacs to four lacs (that is, 800000∶400000, which is equivalent to the ratio 2∶1).
Hence, ratios conveniently summarize data in a form easy to understand, interpret, and compare.
What is the financial ratio?
In accounting, a financial ratio is a ratio that expresses the relationship between two or more accounting figures. For example, a current ratio is a financial ratio that expresses the relationship between current assets and current liabilities.
The concept of the ratio analysis is based on the fact that a single accounting figure by itself does not communicate any meaningful information but when you express in relation to some other figure, it definitely conveys some significant information.
Ratios are useful tools for evaluating a company’s financial position and operations and may reveal areas that need further investigation.
To interpret ratios correctly, the analyst must have:
- A general understanding of the company and its environment
- Financial data for several years or for several companies
- An understanding of the data underlying the numerator and denominator
The ratio analysis requires two steps:
- Calculation of ratio
- Comparison of the ratio with some predetermined standard.
The ratio that measures the firm’s liquidity is called liquidity ratio. Liquidity means the ability to convert assets into cash. Liquidity ratios measure an entity’s ability to pay its short‐term obligations and meet unexpected demands on its cash resources.
The current ratio and Quick ratio are two important measures of short term liquidity.
The current ratio is the ratio of current assets to current liabilities. It compares the current assets to current liabilities to help determine a company’s ability to pay its current obligations. The current ratio is computed by dividing current assets by current liabilities, as shown below.
A low ratio may indicate an inability to meet short‐term debts in an emergency. A high ratio is considered favorable to creditors but may indicate excessive investment in current assets that may not be contributing to profits.
Generally, businesses don’t provide their current ratio on the face of their balance sheets or in the footnotes to their financial statements — they leave it to the reader to calculate this number.
On the other hand, many businesses present a financial highlights section in their financial report, which often includes several financial ratios.
The quick ratio is more restrictive than the current ratio. The current ratio does not provide insight into the company’s ability to pay current liabilities within a short period of time. This is because some current assets, such as inventory, cannot be converted into cash as quickly as other current assets, such as cash and accounts receivable.
The quick ratio overcomes this limitation by measuring the “instant” debt-paying ability of a company and is computed as follows:
The quick ratio is also known as the acid test ratio.
The higher the ratio, the more liquid the entity is considered. A rule of thumb used by some analysts is that a 0.9:1 ratio is adequate. A lower ratio would indicate that, in an emergency, the entity may be unable to meet its immediate obligations.
Profitability means the ability to earn income from its operations. It is the primary purpose of every business. A common measure of profitability is net income.
To evaluate a company’s profitability, you must relate its current performance to its past performance and prospects for the future, as well as to the averages of other companies in the same industry.
The following are the ratios commonly used to evaluate a company’s ability to earn income.
Gross profit ratio
The gross profit ratio expresses gross profit as a percentage of net sales and represents the portion of the sales dollar that is refected in gross profit. It is calculated as follows.
A high ratio of gross profit to sales is a sign of good management. It may also be indicative of a higher sales price without a corresponding increase in the cost of goods sold.
It also likely that cost of goods sold might have declined without a corresponding decline in the sales price.
If the gross profit ratio is lower than expected, then it provides that profit in the business is not sufficient in comparison to sales. This situation is not healthy for the business.
Hence, a low gross profit margin ratio should be carefully investigated.
Profit Margin Ratio
The profit margin shows the percentage of each sales dollar that results in net income. It is an indication of how well a company is controlling its costs: the lower its costs, the higher its profit margin.
The profit margin uses two elements of the income statements: net income and revenues. It is computed as follows.
The profit margin ratio is considered more informative than simply stating profit in absolute terms because it expresses profit as a proportion of sales.
Cost of Goods sold Ratio
This ratio indicates the proportion that the cost of goods sold bears to sales. The cost of goods sold includes the carrying amount of inventory sold. It is calculated as under.
Lower the ratio, the better it is. higher the ratio, the less favorable it is because it would have a smaller margin of gross profit for covering other operating expenses such as office and administrative expenses, selling & distribution expenses, payment of interest, and dividend, etc.
This ratio is calculated by dividing the dividend paid to equity shareholders by the number of equity shares. Hence;
Normally this ratio is used by an investor who is acquiring ordinary shares mainly for dividends rather than for appreciation in the market price of the shares.
Higher the ratio, the more favorable it is because this ratio shows how much income as profit will be received by the investors.
Generally, no company distributes its entire profits as dividend among shareholders. Some part of the profits is kept as reserves for future uncertainties.
Earnings per share (EPS) is the amount of earnings for the period available to each share of common stock outstanding during the reporting period. Earnings per share (EPS) measures the performance of an entity over a reporting period.
EPS is computed by dividing income available to common stockholders by the number of weighted average common shares outstanding during the period.
Higher the earnings per share, better is the performance and prospects of the company. The increasing trend of EPS increases the possibility of more dividends and bonus shares which has a favorable effect on the market value of sare.
Price-Earnings (P/E) Ratio
The price-earnings ratio (P/E ratio) is calculated by dividing the market price of an ordinary share by the earnings per share.
This ratio indicates how much an investor would have to pay in the market for each dollar of earnings. It enhances a statement user’s ability to compare the market value of one ordinary share relative to profits with that of other entities.
P/E ratios vary widely between industries since they represent investors’ expectations for a company.
High P/E ratios are associated with growth companies, whereas more stable companies have low P/E ratios.
The price/earnings ratio can give you some very useful ideas about what other people expect for the future of a company.
For example, when a company’s stock is selling for fifty times earnings (P/E ratio of fifty to one) and the average P/E ratio for most stocks in that industry is fifteen to one, you may conclude that 1) the company’s earnings are going to increase considerably in the future or that 2) the price of the stock is going down between now and the time the present buyers will want to sell the stock.
In general, when the P/E ratio of a company’s stock is significantly higher than average, the buyers of the stock expect that the company will prosper; when the ratio is lower than average, buyers are not optimistic about the company’s future.
Return on Equity (ROE)
Return on equity is the most important ratio associated with stockholders’ equity. Return on Equity (ROE) measures the profitability of a company from the common stockholders’ viewpoint.
Analysts look at the trend over time and compare the company’s ratio to the industry average to determine the profitability of the company.
This ratio is calculated to find out how efficiently the funds supplied by the equity shareholders have been used.
It is computed by dividing net income available for equity shareholders by average equity shareholders funds. When preference shareholders are present, the preference dividend is deducted from net income to compute income available for equity shareholders.
Return on Equity (ROE) is calculated as under:
Higher the rate the more efficient the management and utilization of equity shareholder’s funds.
The return on equity may be higher than the return on assets. The reason for this is effective use of leverage or trading on equity at a gain.
Return on capital employed (ROCE)
Return on capital employed (ROCE) is a broader measure than the return on shareholders’ equity.
ROCE measures the performance of a company as a whole in using all sources of long-term finance. Profit before interest and tax is used in the numerator as a measure of operating results. It is sometimes called ‘earnings before interest and tax’ and is abbreviated to EBIT.
Return on capital employed is often seen as a measure of management efficiency.
Rate of return on assets
The return on assets is another variation on measuring how well the assets of the business are used to generate operating profit before deducting interest and tax.
Long Term Solvency Ratios
Debt to Equity Ratio
The debt to equity ratio reflects a company’s strategy for financing its operations. It shows the proportion of a company’s assets financed by creditors and the proportion financed by the owner.
It is thus a measure of financial risk; the more debt a company has in relation to its owner’s equity, the greater its financial risk.
The debt to equity ratio uses two elements of the balance sheet: total liabilities and total equity
Depending on the industry or sector in which a company operates, a debt-to-equity ratio of 2 to 1 may be fine.
However, if that ratio increases to 3 to 1 or 5 to 1, that might be a red flag that the company has taken on too many liabilities.
Capital Turnover Ratio
Inventory Turnover Ratio
The inventory turnover ratio indicates how fast firms sell their inventory items, measured in terms of the rate of movement of goods into and out of the firm.
Inventory turnover equals the cost of goods sold divided by the average inventory during the period.
The average Inventory is defined as (beginning Inventory balance + ending Inventory balance)/2.
For example, suppose the cost of goods sold totals Rs.100,000 and your average inventory balance is Rs.20,000. Your inventory turnover ratio would be Rs.100,000 ÷ Rs.20,000 = 5.
If a business sells and replaces its stock of Inventory at a rapid rate, turnover is high; if items sit without being sold for long periods, Inventory turnover is low.
There is no widely used rule of thumb available. To decide whether the Inventory turnover figure for a firm is desirable, you must look at previous turnover figures of the firm, turnover figures of other similar firms, and industry-wide averages.
A relatively high turnover figure would suggest that sales are being lost due to shortage of Inventory; a low turnover figure may suggest that demand for the goods is falling, that some of the Inventory cannot be sold, or that prices must be reduced.
A low turnover figure may also indicate that as of the Balance Sheet date too much cash has been invested in Inventory items.
Receivable Turnover Ratio
The receivable turnover ratio is a measure of how many times the average receivables balance is converted into cash during the year. It is also considered a measure of the efficiency of the credit‐granting and collection policies that have been established, and is calculated as follows:
Net credit sales represent sales made on credit, less any sales returns and discounts.
Average accounts receivable is simply the beginning receivable balance for the period plus the ending receivable balance divided by two.
Here’s an example of how to figure accounts receivable turnover:
ABC Company has net credit sales of Rs. 35,000 for the year. Accounts receivable (A/R) was Rs. 2,500 at January 1 and Rs. 1,500 at December 31.
The average A/R is (Rs. 2,500 + Rs. 1,500) ÷ 2 = Rs. 2,000.
The accounts receivable turnover is Rs. 35,000 ÷ Rs. 2,000 = 17.5, or 17.5 times
The higher the receivables turnover ratio, the shorter the period of time between recording a credit sale and collecting the cash.
Frequently, the receivables turnover ratio is divided into 365 days to derive the average number of days it takes to collect receivables from credit sales.
The new ratio so calculated is often called the average collection period for receivables and may be calculated as:
Limitations of Ratio Analysis
Ratios are an excellent way to interpret the results of companies and understand the story behind the numbers but they do have certain limitations. For example:
- Ratios are based on past historical information contained in the financial statements and as such refer to past performance. Past performance is not necessarily an indication of future performance.
While ratio analysis is very useful it should be used in combination with other information when making decisions about investing in or lending to a company.