Analysis of Financial Ratios

 

Analysis of Financial Ratios

What are Financial Ratios

 

Financial ratios are one of the main means of quick decision-making based on the figures available in financial statements. Such Financial Ratios can be used in analyzing the performance of an organization in its history and to compare the organizational performance within the business sector and the industry. Financial ratios are categorized as follows.

•    Profitability Ratios
•        Liquidity Ratios
•        Asset Management/Efficiency Ratios
•        Debt Management/Gearing Ratios
•        Market/Investor Ratios

This article interprets all the financial ratios coming under the above categories and how they are applied to businesses.

  

How to Interpret Financial Ratios

Profitability Ratios

·       Gross Profit Margin

Gross profit margin is calculated as given below and it is expressed as a percentage of turnover. Here, the gross profit is obtained by deducting the cost of sales from the net revenue of the business organization. The ratio indicates the percentage of revenue that exceeds the cost of goods sold for a particular period.

GP Margin = Gross Profit/Turnover

A high-range gross profit margin indicates that the business organization is performing very well over and above its costs.

 

·       Operating Profit Margin

A good operating profit margin indicates that the business organization is performing well as the business is earning enough money to cover the expenses to maintain such business.

 

OP Margin = Operating Profit/Turnover

The operating profit margin is calculated as given above and given as a percentage of turnover.

 

·       Gross Profit Mark Up

The gross profit markup is calculated as given below.

GP Mark Up = Gross Profit/Cost of Sales

Gross profit markup is used to identify how much more a company earns compared to its cost of sales. A good GP markup indicates that the business organization earns higher profits compared to the costs of sales of the product or service.

 

·        Net Profit Margin

Net Profit is obtained by deducting all the expenses from the turnover. Therefore, a higher net profit margin ratio indicates that the business organization is highly profitable.

NP Margin = Net Profit/Turnover

The ratio indicates how much the organization profits per unit of turnover of the organization. The net profit margin ratio is calculated as given above.

 

·       ROCE (Return on Capital Employed)

ROCE is a measure of profitability. The higher the ratio, the better the company performs in terms of profitability. A business organization with a minimum ROCE of 20% is considered as a good performance level. However, the ratio should not be compared with businesses out of the industry as the capital employed factor is considered in calculating the ratio. ROCE is calculated as given below and the capital employed is obtained by the addition of non-current liabilities and equity.

ROCE = Operating Profit/Capital Employed

Capital Employed = Non-current Liabilities +Equity

 

·       ROTA (Return on Total Assets)

ROTA ratio indicates how much profits are generated by the business organization compared to its asset base. A higher ROTA ratio indicates that the business organization generates more earnings from the available asset base of the business organization and the assets are efficient enough to generate such earnings.   

ROTA = Net Profit Before Tax / Total Assets

ROTA is calculated based on the above formula. Here, net profits before tax are used to calculate the ratio.

·       Expenses to Sales Ratio

Expense to Sales = Expense / Turnover

The expense-to-sales ratio is calculated as given above and it indicates how healthy a business organization is to bear the specific expense based on the turnover of the company. The smaller the ratio, the better the organization can generate profits even with a reduction in turnover.

 

·       ROE (Return on Equity)

ROE is calculated as the below-given formula.

ROE = Net Profit After Tax / Equity

The higher the ratio, the better it is. A higher ratio indicates that the business organization generates more gains compared to the cost of equity. This would be a good sign for the investors or equity holders of the business organization as there is a possibility to declare more dividends based on the higher value of net profits after tax.

·       RONA (Return on Net Assets)

RONA = Net Profit After Tax / Net Assets

Net Assets = Total Assets- Total Liabilities

RONA is calculated based on the above formula using the difference between total assets and total liabilities as net assets. This ratio indicates how well the business organization is generating net profits using its net assets. This will be a good sign for the investors that the business organization is performing well. The higher the ratio, the better the business organization is utilizing its assets in generating profits.

 

Liquidity Ratios

·       Current Ratio

Current Ratio = Current Asset/Current Liabilities

Current ratio is calculated by dividing current assets by current liabilities. The ratio indicates the ability of the business organization to meet its short-term obligations using the healthy cash flow of the business organization. The lower the ratio, the better it is as it indicates the sufficient availability of the current assets to meet its current liabilities.

 

 

·       Quick Asset Ratio

Quick Ratio = (Current Assets- Inventory)/ Current Liabilities

The quick ratio is calculated using the current assets except for the inventory. Here, the ratio identifies the ability of the business organization to meet its short-term liabilities with its most liquid assets.

Asset Management/Efficiency Ratios

•        Days Sales Outstanding

Inventory Days Ratio = Average Trade Receivables x 360

                                               Credit Sales

The days sales outstanding ratio is calculated as the above-given formula. The ratio indicates the average number of days required to receive payment for the sale of stock from the debtors. A lower rate indicates a healthy liquidity position of the business organization with the minimum time period for debtor settlements.

•        Inventory Days

Inventory Days = Average Inventory x 360

                                 Cost of Sales

Inventory days are calculated based on the above formula and it indicates how long the stock is in the inventory before it is sold. The lower the number of days in inventory is better for a healthy liquidity position of the company.

 

•        Fixed Asset Turnover

Fixed Asset Turnover = Turnover/ Non-Current Assets

Fixed asset turnover ratio reveals the ability of the company to generate profits using its fixed assets. The higher the ratio, the better the performance of the company, using the fixed assets efficiently and effectively.

•        Asset Turnover Ratio

Asset Turnover = Turnover/ Total Assets

The asset ratio reveals how the company uses its assets to generate more earnings for the company. This further indicates that the company effectively uses its assets to generate such turnover for the company. A higher ratio is favorable for the company as it reveals that the company is making the best use of its assets.

Debt Management Ratios

•  Debt-Equity Ratio (Gearing Ratio)

Gearing Ratio = Debt/Equity

The gearing ratio indicates the financial risk associated with the company. If the ratio is high, the level of risk is also high as the debt level is higher proportion compared to equity. An optimum level of debt is preferred to manage the risk associated with debt and the risk associated with shareholder investments.

•        Debt Ratio

Debt Ratio = Non-Current Liabilities (Debt)/Total Assets

If the debt ratio is larger than one, it indicates that the value of debt is larger than the value of total assets. Such a ratio is not favorable for the company and the associated risk is very high.

 

•        Times Interest Earned/Interest Cover

Times Interest Earned = Operating Profit/Interest Cost

The interest cover ratio is favorable for the company if it is a high ratio only. If the ratio is low, it indicates the level of debt is very high and the company is not in a position to cover the interest with the operating profit. Therefore, the company signals the market signs of bankruptcy. 

Market /Investor Ratios

•       Dividend Cover

Dividend Cover = Divisible Profits/Ordinary Dividends

The dividend cover indicates the company’s possibility to pay dividends to its investors. It further reveals how many times of ordinary dividends can be paid out of the divisible profits.

•        Dividend Yield

Dividend Yield = Dividend Per Share/Market Price per Share

Dividend yield compares the value of the dividend and the market price of shares. This indirectly indicates the percentage of market price per share that is paid to the investors in the form of dividends.

•        Dividend Payout Ratio

Dividend Payout Ratio = Ordinary Dividends /Divisible Profits

The dividend payout ratio indicates the proportion of divisible profits paid out in the form of dividends to the shareholders of the company.

•        Earnings Yield

Earnings Yield = Earnings per Share/Market Price per Share

Earnings yield indicates a value where the value is low, it indicates that the stock is overvalued and where the value is high, it indicates that the stock is undervalued.

•        Earnings Per Share (EPS)

EPS = Divisible Profit/Number of Ordinary Shares

EPS indicates the divisible profits or net earnings that can be allocated to each ordinary share. If the EPS is high, it indicates that the company is profitable.

•        Price/Earnings (P/E) Ratio

P/E Ratio = Market Price per Share / Earnings per Share

PE ratio indicates the value, the market is ready to pay for the company’s stock compared to the earnings per share of this stock which is a historical figure. A high PE ratio indicates that the stock is overvalued compared to the earnings.

•        Price to Book Value (PBV)

PBV = Market Price per Share/Net Assets per Share

PBV ratio indicates the value of a stock compared to the book value of the company. If the ratio is low, it signals the market that the stock is undervalued.

 

 Importance of Financial Ratios

·      Financial ratios indicate the financial health of a business organization by comparing the ratios with its own performance of the previous periods. Such ratios are also supportive in the decision-making of the business organization if there are gaps in the existing performance and further improvements are required to gain healthier ratios.

·      Financial ratios are presented as summarized figures and a ratio is a link between two or more variables. For example, The current ratio is derived from the link between current assets and current liabilities.

   Financial ratios are used to evaluate the performance of the business organization within itself with its prior periods and also externally, with competitors and the ratios established for the particular industry. Therefore, it can be easily identified the performance gaps within the business sector.

·      Financial ratios are easier to handle than a number with six or more digits and the picture given by the ratio is very clear for any person related to finance or non-finance staff. Therefore, such ratios can be used to interpret financial statements especially for non-financial staff.

  

 Limitations of Financial Ratios

·        The financial ratios are only estimates which can be expected within the given time period. It’s a rate to be achieved not the means to make such an achievement. Further, an estimate may not reflect the correct picture due to unethical behaviors such as the manipulation of financial statements within the industry.

·        Financial ratios are always based on historical data. Therefore, therefore, there may be an accuracy problem with using a financial ratio as a measure of future business performance.

·        Off-Balance Sheet Financing is a commonly seen unethical behavior. Therefore, calculating financial ratios based on such balance sheet figures is completely misleading and leads to wrong decision-making as the ratios do not reflect the correct picture behind the scene.

·        Performance is also affected by the cyclical nature of a business. Therefore, making decisions based only on the ratios may be risky for the business if the cyclical nature of the business is ignored.

·        Window dressing or manipulation of financial statements leads to providing wrong financial ratios for evaluating business performance and decision-making. Therefore, ratio comparisons within the industry may be providing misleading information.

B  By C.K.Weerasinghe _ Global Biz Hub