RATIOS IN FINANCE AND HOW TO ANALYZE THEM
Financial ratio analysis is the process of identifying the financial strengths and weaknesses of the firm by properly establishing relationships between the items of the balance sheet and the profit loss account. Financial Analysis can be undertaken by the management of the firm or by parties outside the firm viz owners, creditors, Investors and others. The underlying principle is understanding the past as a prerequisite for anticipating the future. This financial analysis is the starting point for making plans.
The nature of analysis will differ depending on the purpose of the exercise.
a. Trade creditors are interested in firm's ability to meet their claim over a short period of time.
b. Suppliers of long term debts-are concerned with the firm's long term solvency and survival. They analyze the firm's profitability over time, its ability to generate cash to be able to pay interest and repay principal and the relationship betweenvarious sources of funds-capital structure relationships.
c. Investors- are mostly concerned about the firm's earnings. They repose more confidence in those firms that show steady growth in earnings.
d. Management are interested in every aspect of the financial analysis. It is their overall responsibility to see that the resources of the firm are used most effectively and efficiently and that the firm is financially sound.
Nature of Ratio Analysis
Ratio analysis is a powerful tool of financial analysis. A ratio can be defined as the relationship between two or more things financial analysis, a ratio is used as bencnmark for evaluating the financial position and performance of the firm. The absolute accounting figures reported in the financial statement do not provide a meaningrul understanding of the performance and financial position of a firm. An accounting figure conveys meaning when it is related to some other relevant information. A $100 million net profit may look impressive, but the firm's performance can be said to be good or bad only when the profit figure is related to the firm's investment. The relationship between two accounting figures expressed, mathematically is known as a financial ratio.
Ratios help to summarise large quantities of financial data and to make qualitative judgement about the performance of a firm financially. A ratio reflecting a relationship helps to form a qualitative judgement.
STANDARD OF COMPARISON
The ratio analysis involves comparison for a useful interpretation of the financial statements. A single ratio in itself does not indicate favourable or unfavourable condition. It should be compared with some standard, refer to as the standard of comparism. Standards of comparison may consist of:
a. Past ratio: i.e. ratios calculated from past financial statements of the same firm.
b. Competitors ratios i.e. ratios of some selected firms, especially the most progressive and successful competitors, at the same point in time.
C. Industry ratios i.e. ratios of the industry to which the firm belongs.
d. Projected ratios i.e. ratios developed using the projected or proforma financial statement of the same firm.
TYPES OF RATIOS
Several ratios, calculated from the accounting data can be grouped into various classes according to financial activity or function to be evaluated. They may be classified into the following categorizes.
(a) Liquidity ratios
(b) Leverage Ratiops
(c) Activity Ratios
(d) Profitability Ratios
These measure the ability of the firm to meet the current obligations. In fact, analysis of liquidity needs the preparation cash budgets, cash and fund flow statements, but liquidity ratio by establishing a relationship between cash and other current
assets to current obligations, provide a quick measure of liquidity.
A firm should ensure that it does not suffer from lack of liquidity which can result into a poor credit worthiness, loss of creditor's confidence or closure of the company. High degree of liquidity leads to idle assets that earn nothing.
The most common ratios which indicate the extent of liquidity are:
(1) Current ratio, quick ratio, cash ratio, interval measure and net working capital ratio.
(a) Current Ratio: It measures the firm's short term solvency. It is calculated by dividing current assets by current liabilities
Current ratio = Current assets ÷Current liabilities
Quick ratio is a more penetrating test or liquidity than current ratio. It remains an important index of the firms liquidity.
(b) Quick Ratio = Current Assets-Debtors divided by Current Liabilities
(c)Cash-Ratio:- Since cash is the most liquid asset, financial analysts may examine cash ratio and its equivalent to current liabilities. Trade investments or marketable securities are equivalent of cash, they may therefore, be included in the computation.
Cash Ratio = Cash and Marketable Securities divided by Current Liabilities
Long-term creditors are concerned with the firm's long term financlal strength. In determining this, financial leverage or capital structure ratios are calculated. These ratios indicate mix of funds provided by owners and lenders.
The manner in which assets are financed has a number or implications.
1. Debt is more risky from the firm's point of view. The firm
has to pay interest to debt holders, irrespective and whether profit is made or loss incurred.
2. The use of debt is advantageous to shareholders in that (a) they can retain control of the firm (b) there earning will be magnified, when the firm earns a rate of return on the total capital employed higher than the interest rate on the borrowed funds. The process of magnifying the shareholder's return through the use of debt is called "financial leverage" or "financial gearing" or "trading on equity.
3. A high debt-burdened firm will find difficulty in raising funds from creditors and owners in future.
DEBT RATIO: This can be used to analyze the long-term solvency of a firm. The firm may be interested in knowing the proportion of the interest- bearing debt in the capital structure.
TIMES-INTEREST RATIO: Debt ratios are static in nature and fail to indicate the firm's ability to meet interest and other fixed charge obligations. The interest coverage ratio or Times Interest earned is used to test the firm's debt servicing capacity. The interest coverage ratio is computed by dividing earnings before interest and taxes by interest coverage.
The interest coverage ratio shows the number of times the lnterest charges are covered by funds that are ordinarily available for their payment. Since taxes are computed after interest, interest coverage is calculaied in relation to earnings before taxes.
Depreciation is a non-cash item, funds equal to depreciation are also available to pay interest charges. We can thus calculate the interest coverage ratio as earnings before depreciation, interest and taxes divided by interest.
This ratio indicates the extent to which earnings may fall without causing any embarrassment to the firm regarding the payment or the interest charges. A higher ratio is desirable. But too high a ratio indicates that the firm is very conservative in using debt and that it is not using credits to the best advantage of share holders. A lower ratio indicates excessive use of debts or inefficient operations.
Funds of creditors and owners invested in various assets generate sales and profits. The better the management of assets, the larger the amount of sales. Activity ratios are employed to evaluate the eficiency with which the firm manages and utlizes is assets. These ratios are also called turn-over ratios because they indicate the speed at which assets are being converted into sales. Activity ratios, thus, involve a relationship between sales and assets. A proper balance between sales and assets generally reflects that assets are managed well. Several activities ratios can be calculated to judge the effectiveness of assets utilization.
INVENTORY TURNOVER: inventory turnover ratio indicates the efficiency of the firm in producing and selling its products. It is calculated by dividing the cost of goods sold by the average inventory:
Inventory Turnover = Cost of goods sold÷Average Inventory
The inventory turnover shows how rapidly the inventory is turnedover into receivables through sales. A high inventory turnover is indicative of good inventory management. A low inventory turnover implies excessive inventory levels than warranted by production and sales activities or a slow moving or obsolete inventory.
COLLECTION PERIOD: The average number of days for which debtors remain outstanding is called the Average Collection Period (ACP) a can be computed as ACP. The average collection period (ACP) measures the quality of debtors since it indicates the speed of their collection. Short collection period implies the prompt payments by debtors. ACP should be compared against the firm's credit terms and policy to judge its credit and collection efficiency. If the credit period granted by a firm is 35 days and its ACP is 50 days, this reveals that the firm's debtors are outstanding for a longer period than warranted by the credit period. A liberal and inefficient credit and collection performance. This impairs the firm's liquidity.
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 maximizing profits, irrespective of social consequences. But it is a fact that sufficient profits must be earned to sustain the operations of the business, to be able to obtain funds from investors for expansion and growth and to contribute towards the social welfare of the society.
Profit is the ultimate 'output of a company and it will have no future if it fails to make sufficient profits. The financial manager should continuously evaluate the efticiency of the company in terms of profits. Besides, management, creditors, and owners are also interested in the profitability of the firm. Generally, two major types of profitability ratios are calculated:
Profitability in relation to sales
Profitability in relation to investment
The ratio indicates the average spread between the cost of goods sold and the sales revenue. A high gross profit margin ratio is a sign of good management. It is occasioned by (1) higher sales prices, with constant cost of goods and (i) Lower cost of goods with constant sales prices. Or the combination of both.
A low gross profit margin reflects higher cost of goods due to:
a. Firm's inability to purchase raw materials at favourable terms:
b. Inefficient utilization of plants and machinery.
c. Over investment in plants and machinery.
CAUTIONS IN USING RATIO ANALYSIS
The ratio analysis is a widely used technique to evaluate thefinancial position and performance of a business. But there are certain problems in using ratios. The analyst should be aware of these problems. The following are some of the limitations of the ratio analysis.
1. It is difficult to decide on the proper basis of comparison.
2. The comparison is rendered difficult because of differences in situations of two companies or of one company over years.
3. The price level changes make the interpretations of ratios
4. The differencesin the definitions of items make the interpretation of ratios difficult.
5. The ratios calculated at a point in time are less informative and defective as they suffer from short term changes.
6. The ratios are generally calculated from past financial invalid. Statements and thus are no indicators of future.