Analyzing Financial Statements
Ratio Analysis
Analyzing
financial statements is a process of evaluating a firm's past financial
performance and its future prospects. The process requires the application of
common sense and judgement in addition to analytical techniques. As we already
know, there are many users of a firm's financial data : Creditors, owners and
management, suppliers, competitors etc.
The analysis helps the above users in understanding the numbers presented
in statements and serves as a basis for financial decision making.
Ratio analysis is perhaps the most commonly used
analytical tool in financial statement analysis. It helps to reveal the overall
financial condition of a firm.
For example, Investors look at ratios to evaluate a
company's performance and growth.
Banks and creditors look
at ratios to determine how much credit/loan to grant a firm.
Creditors worry
when a firm does not generate enough earnings to make periodic payment of
interest on outstanding debt. Managers use financial ratios to monitor
operations, to make sure that their firms are using the available resources
efficiently. The idea is to see whether the firm's financial and operating
status is improving over time and whether its overall ratios are better or
worse than the ratios of competing companies.
Ratios are
classified into FOUR major
categories:
|
Classification |
Types
of ratios |
What
is the purpose? |
|
LIQUIDITY |
a) Current ratio b) Quick ratio
(acid-test ratio) |
They measure the
firm's ability to meet short-term obligations/liabilities from its current
assets. |
|
ASSET
UTILIZATION |
a) A/R turnover ratio b) Average collection period c) Inventory turnover ratio d) Fixed assets turnover ratio e) Total assets turnover ratio |
It measures how
frequently a firm converts its current assets into cash. It also measures
how well a firm uses its Fixed assets and total assets to generate sales. |
|
DEBT UTILIZATION |
a) Debt to Total assets ratio b) Times interest earned ratio c) Fixed charges coverage ratio |
It measures the
amount of debt financing used by the company. It also measures
the firm's ability to meet interest payments. |
|
PROFITABILITY |
a) Profit margin ratio b) Return on Assets c) Return on equity |
It measures the
effectiveness of management in generating profits on sales, total assets and
owners' equity. |
1. Liquidity ratios
1.1 Current ratio
Current
assets
Current ratio
= ---------------
Current
liabilities
Purpose : It measures
the firm's ability to meet its current liabilities out of
Its current assets.
Implication :
|
High
current ratio |
Low
current ratio |
|
A high ratio may
suggest that the firm is holding too much capital in the Form of current
assets |
A low ratio
suggests that the firm may have difficulty paying its bills |
1.2
Quick ratio
Current assets --
Inventories -- Prepaid expenses
Quick ratio
= ---------------------------------------------- Current
liabilities
Purpose : Also known as the acid-test ratio; it
measures short-term liquidity by
removing the least
liquid current assets, such as inventories and prepaid
Items.
Implication :
|
High
Quick ratio |
Low
Quick ratio |
|
A high ratio
suggests that the firm is in a position to meet its short term commitments
out of the most liquid assets. |
A low ratio
suggests that a large portion of current assets is in the form of less liquid
assets |
Task 1 : Calculate
the liquidity ratios for Falcon manufacturing company given in the appendix.
2. Asset Utilization ratios OR Activity ratios OR Efficiency ratios
Asset utilization
ratios ( Fixed assets turnover ratio
and Total assets turnover ratio )
usually
compare sales with the level of investment in assets. The purpose is to
determine
how well a firm
utilizes its assets.
Other
activity ratios ( A/R turnover ratio and Inventory turnover ratio ) determines
the
efficiency
of management in using these assets.
2.1
Accounts receivable turnover ratio
Net sales
A/R turnover ratio =
--------------
Accounts receivable
Note :
If information is available on Credit sales; then Net sales should be
replaced by Credit sales in the numerator.
Purpose : This ratio
indicates how many times accounts receivable are collected during
the year.
Implication :
|
High
A/R turnover ratio |
Low
A/R turnover ratio |
|
A high turnover
ratio suggests that the firm is very efficient in collecting its
receivables. It could also mean that
the firm may be giving a very short credit period to its customers |
A low turnover
ratio may suggest that the company is too lenient in its credit policy or is
not quite effective in collecting its receivables |
2.2
Average Collection period
Accounts receivable
Average
collection period = ----------------------
Average daily credit sales
OR
Accounts receivable
Average
collection period =
------------------ X 365 days
Net sales
Purpose : The
measure indicates how many days a firm takes to convert its receivables into
cash. This ratio is used to evaluate credit and collection policies of the
firm. This measure should always be compared with the credit terms of the
company.
Implication
:
|
Long
collection period |
Short
collection period |
|
If the
collection period considerably exceeds the credit period, it means the firm
is not effective in collecting its receivables. A long collection period
reduces the liquidity of the receivables and affects the firm's ability to
meet short-term maturing commitments |
A short
collection period may suggest that the firm is too restrictive in its credit
policy. That is, it does not offer sufficient credit and hence may be losing
out on sales |
2.3
Inventory turnover ratio
Sales
Inventory turnover ratio = -----------
Inventory
Purpose : It measures
the efficiency of the firm in terms of managing and selling
inventory.
(The
type of industry would also play a part in assessing this ratio.
For instance, a grocery store would have a
higher inventory turnover than a
firm selling furniture.)
Implication :
|
High
inventory turnover ratio |
Low
inventory turnover ratio |
|
A high inventory
turnover generally indicates good buying practices. It also means that the
firm is selling items quickly implying improved liquidity and profitability
because less money is tied up in inventory. On the other
hand, it might also suggest that the firm may not be keeping sufficient
inventory on hand and thereby losing out on sales. |
A low inventory
turnover may suggest that the firm is carrying excess inventory or obsolete
inventory. It could also
suggest that the firm is piling up inventory because of higher anticipated
sales in the near future. |
2.4 Fixed assets turnover ratio
Net
Sales
Fixed assets turnover ratio =
-----------------
Net
Fixed Assets
Purpose
: It indicates management's efficiency in managing fixed assets.
Implication
:
|
High Fixed
assets turnover ratio |
Low Fixed assets
turnover ratio |
|
A high turnover
ratio suggests that fixed assets are being used productively. |
A low turnover
ratio may suggest too much of investment in fixed assets, low sales or a
combination of both. Analysts must
further investigate and ask questions such as : a) How old are
the assets? b) Is the
machinery & equipment obsolete? |
2.5 Total
Assets turnover ratio
Net
Sales
Total assets turnover ratio =
-----------
Total
assets
Purpose
: It measures how well total assets are used in generating
sales. It is a composite measure of all other asset utilization ratios.
Implication
:
|
High
Total assets turnover ratio |
Low
Total assets turnover ratio |
|
A high ratio
suggests greater efficiency in using its assets to generate sales. |
A low ratio
suggests less efficiency in using its assets to generate sales. |
Task 2 : Calculate
the asset utilization ratios for Falcon manufacturing company given in the
appendix.
3. Debt Utilization Ratios
These are also known as solvency ratios or leverage ratios. The ratios
in this category show
the extent to which a firm uses debt (borrowings)
to finance its investments and its ability
to meet interest charges and other fixed
payments.
3.1 Debt to Total Assets ratio
Total liabilities
Debt to total assets ratio =
--------------
Total Assets
Purpose
: It measures the percentage of assets that have been financed
by debt (borrowings). Financial
leverage is the extent to which a firm uses debt financing. As the
percentage of debt financing increases, the firm becomes highly leveraged. The amount of financial leverage implies risk
to creditors
and
owners.
Implication :
|
High
Debt to total assets ratio |
Low
Debt to assets ratio |
|
A high debt to
total assets ratio implies more of the firm's assets are financed by debt
relative to owners' funds. A high ratio
requires the commitment of more funds to pay interest and repay principal
amount. The failure to meet these requirements may
force a company to bankruptcy. A highly
leveraged firm may also find it difficult to attract additional debt
financing. Positive aspects of high leverage Although
leverage implies risk, it also provides the common shareholders with the
opportunity to enhance their return. Shareholders
also maintain control because using debt avoids the sale of new shares. |
A low debt to
total assets ratio implies that the firm is using more of owners capital and
retained earnings to finance its assets. It implies less
risk to creditors. Company can borrow additional funds with relative ease. |
3.2 Times Interest Earned ratio
Earnings before interest and taxes (EBIT)
Times interest earned
ratio =
------------------------------------
Interest
expense
Purpose
: The purpose is to measure the firm's ability to meet interest
payments out of its operating profit.
Implication :
|
High
Times interest earned |
Low
Times interest earned ratio |
|
A high ratio
suggests that the firm is quite safe in meeting its interest payments. In other words,
earnings could fall slightly without jeopardizing the firms ability to meet
interest payments. |
A low ratio
suggests more risk to creditors because they may not get the interest that is
due to them. Therefore the
firm may face difficulty in borrowing additional funds. |
3.3
Fixed charges coverage ratio
EBIT +
Lease payments
Fixed
charges coverage ratio =
------------------------------
Interest expense + lease payments
Purpose : It is a broad
measure of the firm's ability to meet all fixed charges and
interest payments.
A lease is a contract
between the owner of an asset called the lessor,
and the another party called the lessee,
who makes periodic payments to the owner for the right to use the asset.
Implication
:
|
High Ratio |
Low Ratio |
|
A high ratio
implies that the firm has a bigger cushion in case of worsening financial
position. It means less risk to creditors. |
A low ratio
suggests that the creditors are more at risk. If earnings decline, the
company may not be able to meet its obligations. |
Task 3 : Calculate
the debt utilization ratios for Falcon manufacturing company given in the
appendix.
4. Profitability
Ratios
These ratios measure the earning power of
the firm. They are used to evaluate the overall
management effectiveness. Specifically,
they indicate how effectively a firm's management
generates profits on sales, total assets and equity.
4.1 Profit
Margin Ratio (Net Profit Margin)
Net
Income
Profit
Margin Ratio = ---------------
Sales
Purpose : It measures
the percentage of each sales dollar remaining after deducting
all expenses.
Implication :
|
High
Ratio |
Low
Ratio |
|
A high ratio
suggests that expenses as a percentage of sales are under control indicating
operational efficiency. It could also suggest that price realization is very
good or a combination of both the factors mentioned above. |
A low ratio may
suggest that expenses as a percentage of sales are high or the firm is losing
out on sales. |
4.2 Return
on Assets
Net
Income
Return
on Assets = ---------------
Total
Assets
Return
on Assets = Profit Margin Ratio X Total Asset
turnover
= Net income Net Sales
---------- X ---------
Net
sales Total Assets
Purpose : This ratio measures the overall
effectiveness of management in
generating profits from
its total investment.
Implication :
|
High
Ratio |
Low
Ratio |
|
A high ratio is
favorable. It implies that net income as a percentage of total sales is good
(Profit margin ratio) or the firm is able to generate a high level of sales
given its investment in assets (Total assets turnover) or a combination of
both. |
A low ratio is
unfavorable. Further analysis needs to be done to ascertain the reasons. Is
it due to lower profit margin or is it due to low asset turnover? |
4.3 Return
on Equity (ROE)
Net
Income
Return
on Equity = ------------------
Shareholders'
equity
OR
Return
on Equity = Profit margin X Total assets X Financial
ratio turnover leverage
= Net income Net Sales Total assets
-----------
X ---------- X
-----------
Net
sales Total assets Sh. Equity
Purpose : It measures the rate of return realized by
a firm's shareholders on their
investment and is the
indicator of management performance.
Implication :
|
High
Ratio |
Low
Ratio |
|
A high ratio is
generally associated with effective management performance. Further analysis
might indicate the reasons of a higher ROE. How ever, a higher ROE may also
suggest that a firm is more risky due to higher leverage. |
A low ratio
suggests ineffective management performance.
Further analysis must be done to find the reasons. Is it due to Profit
margin, or is it due to lower asset turnover? A low ROE may also suggest that
the firm is more conservatively financed (lower leverage). |
Task 4 : Calculate
the profitability ratios for Falcon manufacturing company given in the
appendix.
The following
information has been extracted from the
accounts of Falcon Manufacturing company.
Falcon Manufacturing Company
Income Statement for the
years ended
(all figures in '000 AED)
1997 1998
|
Sales (all
credit) |
|
7,650 |
|
11,500 |
|
Less : Cost of
sales |
|
5,800 |
|
9,430 |
|
Gross profit |
|
1,850 |
|
2,070 |
|
Less : Operating expenses |
100 |
|
120 |
|
|
Lease payments |
50 |
150 |
50 |
170 |
|
Operating income
(EBIT) |
|
1,700 |
|
1,900 |
|
Less : Interest expense |
|
50 |
|
350 |
|
Earnings before
Tax |
|
1,650 |
|
1,550 |
|
Less : Taxes |
|
600 |
|
550 |
|
Earnings after
Tax |
|
1,050 |
|
1,000 |
|
Dividends
paid(common shares) |
|
300 |
|
300 |
|
Transferred to
Retained Earnings |
|
750 |
|
700 |
|
|
|
|
|
|
|
Falcon
Manufacturing Company Balance
Sheet as at |
||||
|
Current Assets |
|
|
|
|
|
Cash |
900 |
|
50 |
|
|
Accounts receivable |
1,200 |
|
3,800 |
|
|
Inventory |
1,500 |
|
2,450 |
|
|
Total Current
Assets |
|
3,600 |
|
6,300 |
|
Net Fixed Assets |
|
10,050 |
|
11,350 |
|
Total Assets |
|
13,650 |
|
17,650 |
|
|
|
|
|
|
|
Current Liabilities |
|
|
|
|
|
Accounts payable |
1,800 |
|
2,150 |
|
|
Tax payable |
600 |
|
550 |
|
|
Total Current
liabilities |
|
2,400 |
|
2,700 |
|
Long-term debt |
|
350 |
|
3,350 |
|
Total Liabilities |
|
2,750 |
|
6,050 |
|
|
|
|
|
|
|
Shareholders' Equity |
|
|
|
|
|
Common shares, AED 10 par |
5,900 |
|
5,900 |
|
|
Retained Earnings |
5,000 |
|
5,700 |
|
|
Total Shareholders' equity |
|
10,900 |
|
11,600 |
|
Total liabilities & Sharholders'
equity |
|
13,650 |
|
17,650 |
|
RATIOS |
1997 |
1998 |
COMMENTS |
||
|
LIQUIDITY |
|
|
|
|
|
|
Current ratio |
|
|
|
|
|
|
Quick ratio (acid-test ratio) |
|
|
|
|
|
|
UTILIZATION |
|
|
|
|
|
|
A/R turnover
ratio |
|
|
|
|
|
|
Average
collection period |
|
|
|
|
|
|
Inventory
turnover ratio |
|
|
|
|
|
|
Fixed assets
turnover ratio |
|
|
|
|
|
|
Total assets
turnover ratio |
|
|
|
|
|
|
DEBT RATIOS |
|
|
|
|
|
|
Debt to Total
assets ratio |
|
|
|
|
|
|
Times interest
earned ratio |
|
|
|
|
|
|
Fixed charges
coverage ratio |
|
|
|
|
|
|
PROFITABILITY |
|
|
|
|
|
|
Profit margin
ratio |
|
|
|
|
|
|
Return on Assets |
|
|
|
|
|
|
Return on equity |
|
|
|
|
|