A valuable tool of financial statement analysis is known as ratio analysis. A ratio is a mathematical expression of the relationship of one figure to another. Business ratios are also a crucial part of Business Planning. Below, we’ll be looking at the calculation and significance of the most important financial ratios.
SIGNIFICANCE OF RATIOS
There are many limitations to the conclusions that may be drawn from the size of individual items in financial statements. For this reason, ratios are often regarded as being more significant indicators.
CALCULATION OF RATIOS
A ratio is calculated simply by dividing one figure by another. The result may be expressed in several ways: as a percentage, as a digit, or as a fraction.
SHORT TERM FINANCIAL RISK
Ratios in this category are possibly those of most interest to the credit analyst. Each of the following ratios evaluates current assets in relation to other items:
- Current Ratio: The larger the ratio the greater the protection for short term creditors.
Current Ratio = Current Assets / Current Liabilities
- Liquid or Quick Ratio: Sometimes called the “Acid Test”. It provides a far better indication than the current ratio of the capacity of a business to meet its immediate financial obligation. Mainly because Current Assets include inventory and assets that must be sold first whereas Liquid Assets are cash or assets that can be easily turned into cash on relatively short notice.
Liquid Ratio = Liquid Assets / Current Liabilities
- Receivables Turnover:
Receivables Turnover = Net Credit Sales / Accounts Receivables
As previously indicated, an aging of accounts receivable is desirable. However, in its absence, a calculation of receivables turnover is very helpful. This shows the number of times per year accounts receivable are converted into cash.
Collection Period = 360 / Receivables Turnover
= ( Accounts Receivables x 360 ) / Net Credit Sales
This result is then directly comparable to the credit terms on which the firm operates.
- Inventory Turnover: Indicates how many times per year inventory is sold.
Inventory Turnover = Cost of Goods Sold / Inventory
The Inventory Turnover can also be expressed in the number of days the inventory is held in stock before being sold.
Inventory Turnover = 360 / Inventory Turnover
In Days
= ( Inventory x 360 ) / Cost of Goods Sold
As with receivables, it is desirable to use an average inventory figure (Opening stock + Closing stock) divided by 2.
- Inventory To Working Capital: Indicates whether the company can adequately finance the inventories.
Inventory to Working Capital = Inventory / Net Working Capital
Working Capital Turnover: Helps determine whether the company is over trading. That is, conducting too large a volume for the amount of working capital employed in the business.
Working Capital Turnover = Net Sales / Working Capital
If the ratio is too large then the company is overtrading. The problem with this data is that any fast adverse change in business conditions works against this type of operator and usually creditors will be adversely affected.
LONG TERM FINANCIAL RISK
While the working capital position of a company is of the most immediate concern to a trade creditor, he/she must also gain some knowledge of the longer term condition.
The position of creditors is always stronger when the liabilities are small in relation to assets. This is true of both current and long term liabilities.
- Debt/Equity Ratio: Indicates the extent of permanent capital compared with other forms of debt and borrowings. It is a measure of the company’s leverage or gearing.
Debt/Equity Ratio = Total Liabilities / Shareholders’ Equity
- Fixed Assets To Equity: From the creditor’s viewpoint, the extent and financing of fixed assets is important since while these assets may be essential to the operations of the business, they are not available for the payment of business debts.
Fixed Assets/Equity Ratio = Fixed Assets / Shareholders’ Equity
Interest Cover Ratio: Measures the company’s ability to meet interest charges on long term debt. In default, the full maturity of the debt may become immediately payable, hence placing a very heavy financial strain on the business.
Interest Cover Ratio = Net Profit Before Interest & Tax / Interest Expense
- Deferred Debt To Working Capital: This ratio shows the relationship between deferred debt and working capital. It is important to note that even where default on interest payments does not occur, heavy interest payments and the necessity of meeting current maturities on deferred or long term debt may impact the working capital position of the firm.
Deferred Debt To Working Capital Ratio = Deferred Debt / Working Capital
PROFITABILITY
There are several ratios that may be calculated to analyse the profitability of a company. Many of these are of greater concern to the firm’s management team than the company’s creditors. Below, we’ll be discussing only the major ones.
It is important to note that a firm may show a favourable financial position but, its profitability may prove to be low in comparison to industry standards.
- Rate of Return on Assets: Is a major indicator of the profitability of a firm’s operations. This should at least be on par with industry standards.
Rate of Return on Assets = Net Profit / Total Assets
If the Rate of Return on Assets falls below the average for the industry, further investigation may be carried out to determine the causes.
One line of further investigation is to restate this ratio as follows:
Rate of Return on Assets = Net Profit/Net Sales = Net Sales/Total Assets
= Net Profit Margin = Asset Turnover
- Rate of Return on Shareholders’ Funds: This ratio indicates shareholders the rate of return on their investment.
Rate of Return on Shareholders’ Funds = Net Profit / Shareholders’ Equity
Shareholders will demand a competitive rate of return on their investment.
If the rate of return on shareholders’ funds fall below the industry standards, the company may find it difficult to raise further capital.
However, if the rate of return is substantially higher than industry standards this may indicate a higher level of risk associated with heavy debt financing.
CONCLUSION ON BUSINESS RATIOS
Ratio analysis offers the analyst, a very simple method of highlighting important relationships between items in the financial statements.
And, if used with caution, it can be an invaluable tool in the estimation of the credit worthiness and financial situation of a business.
