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Introduction to Finance
Question
1. How to make ratios meaningful
Ratio analysis is defines as a tool to evaluate business performance of a corporation. Hence, financial statement can be interpreted by using ratios and perspective of it could be used to analyze, control and even improve performance of a company. Generally, primary purpose of ratios is to point out areas of weakness and strengths so further investigations can be made. On top of that, figures obtained through ratios can help managers study the efficiency of operations and the risks encounter, so effective actions could be taken immediately. In brief, financial ratio is a guide to a company. Individual ratios are usually of a very limited value. Ratios by themselves are not that helpful and meaningless A big figure ratio by itself cannot be said that the firm is performing well because it has to be depending on other companies’ performance as well. Thus, ratios to be really useful, comparison are a must. Therefore, ratios calculated need to be compared with other companies’ ratios in order to determine that the figure obtained is good or bad. Actually, there are many ways of comparing could be done:-
1. Comparison between present with previous results
2. Comparison between present with forecast
3. Comparison with other competitors
4. Inter-firm comparison (IFC)
5. Comparison with industry market leader
1. Comparison between present with previous results
Firstly, comparison could be done by comparing the current year performance with previous years to determine trends the firm is moving towards. Through this, corporation can also analyze whether the businesses had increase or decrease. If it is bad, further actions that necessary can be taken immediately to boost back the businesses that fall. Take a corporation, Bell Bhd as example. Let say the Bell Bhd current ratio of 2008 is 2.5 times meanwhile in 2007 the ratio is 2.3 times. By looking both results it can be said that the year 2008 current ratio is much better than year 2007. This means the liquidity position of the company to meet short-term obligations had become even stronger than previously. Nonetheless, comparison between two years is insufficient to observe the trend. If given the results for say five to six years, more reliable trends may be discerned because trends is essential as it may signal to investors whether they should stay with their investment or sell it and re-invest in a more promising venture.
2. Comparison between present with forecast
A part from that, ratios can used to compare with budget predict by the firm. This is to see whether the ratios calculated is the same as the target the corporation wants to reach. If it is not, the corporation is not doing well and if it is the same result with forecast or obtain even much better result, then it can be said that the corporation is performing well. By taking previous example in paragraph above, current ratio of 2008 is 2.3 times and given the budget estimated at 2.5 times. Comparing both results, a summary can conclude for the differences is that the firm credit customers had reduced or the firm is having cash flow problem. On the other hand, it can be also said that the numbers of suppliers had risen or amount of overdraft is more than expected.
3. Comparison with other competitors
Furthermore, ratios obtained can be used to compare with other rivals. Even when this is done, it is important that the competitors are valid as ratios are only accurate when comparison is made with the same field competitors. There is not much point in comparing of a car with that of a bicycle. Like must be compared with like. For instance, racing bike to racing bike, car to car, mobile phone to mobile phone and so on is what considers as the perfect and fair comparison. For companies, the easiest way to ensure that like is being compared with like is to compare companies that operate in the same business sector. An example, Nokia and Sony Ericsson are both selling the same products which is mobile phone, therefore both of them is compatible to make comparison. If found out that Nokia position is below Sony Ericsson, action in improving the mobile phone function or plan to promote new model of phone by Nokia could be great to outrun Sony Ericsson. Same goes to Sony Ericsson if their position is weaker than Nokia. Appropriate action must draft out properly from the team management of Sony Ericsson to war against Nokia.
4. Inter-firm comparison (IFC)
Ratios can also compare to industry average which known as inter-firm comparison. In depth, inter-firm comparison is possible when information about the performance of other similar businesses is available. Trade associations collect information from their members and publish the statistics as averages for the industry. It is thus possible to compare the results of one company with the averages for businesses of the same type. Comparisons, however, must be made with care. It is not realistic to compare the statistics of a small trader with results achieved by large companies. Comparisons should always be on a like-for-like basis as far as possible. Briefly speaking, inter comparison is a guide to inform shareholders whether they have invested their money in the most profitable and stable institutions. Let take an example for situation above, Bell Bhd where is far behind the industry average has indicates the company is deteriorating and probably may face insolvency in future. If the Bell Bhd ratios are above the average, the company is to be state as good condition. When a corporation is above the average, most of the shareholders will prefer to invest in the firm due to stability and this can fund the company do to further investment in praying high dividend will be paid to the shareholders in the following year. Hence, if a company left far behind does not mean it is the end of the road, there is still hope to bring up the business. First step is to investigate problems that cause the failure and later on, think of quick and precise action to solve the problems encountered.
5. Comparison with industry market leader
Lastly, ratios can be used to compare with the industry best practice. In every field, of course there is one company that led the market. Therefore, ratios of a firm must compare with the market leader firm of the same industry in order to improve. Through this, company will know how wide the gap is and try to wind up the space between them. Nowadays, fast food restaurants have become more advanced and popular among the population in the whole world. With that, many of the fast food restaurants have build up and think of new ideas to become the top ranking in the world. McDonald’s for example, is a well known fast food restaurants globally and their services and food quality had always improving since the first day it had operated and their hard work did pay off eventually with the ranking of number five at the moment. Nonetheless, they had to compare with number industry best practice which is Wendy’s fast food restaurant that currently ranked number one. Apparently, McDonald’s needs to put in more efforts to take over number one place. It is normal in an industry that every corporation established wish to be on top world, therefore competition always presence without doubt.
2. The various types of ratios used to evaluate a company
Financial ratios fall into five main categories:-
1. Profitability Ratio
2. Liquidity Ratio
3. Capital Structure Ratio
4. Asset Management Ratio
5. Market Value Ratios
2.1 Profitability Ratio
One of the fundamental objectives of businesses is to make a satisfactory return for their shareholders. The term return usually means profit, and it is the profit motive that really drives the business. It is therefore important that there are some reliable measures of the profitability of businesses. The purpose of this ratio is for shareholders to see whether the company they invested making satisfactory profits or not. If the company does make good return, then the investors and shareholders will continue provide capital to it and vice versa. Besides that, they are also used among other things, for instance measure the performance of management, to identify whether a company makes a worthwhile investment and to determine a company’s performance relative to its competitors. Take note that this ratio is very vital and therefore must obtained good results as it concerns the journey of a company in long-run. Survivability of a firm depends heavily on this ratio. In depth, there are 6 ratios under this profitability ratio.
1. Gross profit margin
2. Operating Profit Margin
3. Net Profit Margin
4. Return on Assets (ROA)
5. Return on Equity (ROE)
6. Return on Capital Employed (ROCE)
1. Gross Profit Margin
This gross profit margin ratio shows how much of each sales dollar is available to pay expenses. In addition, it also can reveal how efficiently a business is using its labor and materials in the production process by looking at the ratio percentage. No doubt for this ratio, the higher the ratio goes the better. The gross profit dollar figure is calculated by subtracting cost of sales from sales value and dividing the remainder by sales. Below shows the formula of gross profit margin:-
Gross Profit Margin =
It has to depend on the result of this analysis. Any variations could due to many reasons. Selling prices may be too high or low, costs may be too high or low, volumes may be different and the mix of products sold may be different. As for the company that have higher ratio compare to previous year could be either low cost from suppliers, charging a higher price or a combination of both factors that make the ratio look good.
2. Operating Profit Margin
The objective of this ratio is to examine operating profitability of a company. Therefore, the denominator of earnings before interest and tax (EBIT) is used in calculation. The reason behind it is because earnings before interest and tax had already subtracting operating expenses from gross profit, so companies will get to knows whether their expenses is under control or too over the top. Thus, higher ratio means better control over its expenses whereas lower ratio indicates poor control over operating expenses. It is computed through dividing earnings before interest and tax by sales and later converts it into percentage. Formula is shown below:-
Operating Profit Margin
3. Net Profit Margin
Net profit margin is actually a ratio that measures corporate profitability on a per dollar-of-sales basis. Generally, the higher the ratio, the more profit earned from each dollar in sales. It is computed by net earnings available to common stockholders by sales. Net earnings available to common stockholder is an amount after deducting all expenses including tax, interest and preferred dividends from sales value. For every corporation, all expenses, interest, tax and preference dividends is a must to pay even making loss or profit and that is why net earnings available to common stockholders is use as denominator in calculation. If a firm has low percentage on this ratio indicates the company not capable to control their expenses or sales had drop due to inflation. On the other hand, if a firm has high percentage of this ratio shows their company can handle well on expenses or sales volume had increase due to pricing strategy set by the manager. Box below show the formula of net profit margin:-
Net Profit Margin =
Different management and action taken could affect the ratio to change. Moreover, control over expenses is also essential as poor control affect badly on the ratio and vice versa. With that, management must not take easy on expenses and expenses must always be watched.
4. Return on Assets (ROA)
This ratio gives an indication how well the business is utilizing its assets, regardless of how they are financed. In simple phrase, it measures corporate profitability per dollar of assets. Return on assets is calculated by dividing net earnings available to common stockholders with total assets in percentage form. The formula will be shown below:-
Return on Assets (ROA) =
Let make an assumption that a firm return on assets is 30% from funds used to finance its total assets. From the percentage, it indicates that 30 cents of profit will obtain for each dollar of assets. Generally, return on asset ratio essentially relates size of profits. If a corporation increases in size as measured by total assets but does not increase its earnings after taxes and preferred dividends proportionally, then it’s the ratio will decrease. Thus, increasing the corporation’s size will not of itself advance welfare of its shareholders.
5. Return on Equity (ROE)
The return on equity ratio relates a corporation’s profits to its equity sources. Generally, the higher the return on equity, the more profit is earned for owners of the company which is the ordinary shareholders, the capital contributors to firms. In another words, it measures corporate profitability per dollar of equity capital. Therefore, this ratio is just specifically for shareholders as ii aimed at measuring the return they should expect from their shares in the business. This ratio is computed by dividing net earnings after taxes and preferred dividends by stockholders’ equity.
Return on Equity (ROE) =
6. Return on Capital Employed (ROCE)
Return on capital employed ratio tells how much the capital invested has earned during the period of time. An adequate return on capital employed is what many investors seek and is therefore one of the main reasons why people invest their money in a business in the first place. As a result, this is an extremely important ratio. Return on capital employed is slightly different than the ratio mentioned in previous paragraph, as it in include long term debt with preference and equity capital that called as capital employed which is reflect wider view. It is calculated through dividing operating profit by capital employed. Below show the method to calculate this ratio:-
Return on Capital Employed (ROCE) =
2.2 Liquidity Ratio
Liquidity ratio measures the ability of companies to convert current assets into cash and ability to meet short-term obligations. Suppliers and providers of short term finance are keen in these ratios as it provides information whether the company has the power to settle its current liabilities. Generally, a basic financial management principle is to ensure that the business remain solvent or liquid. Being able to pay one’s debts as they fall due is known as being liquid. However, insolvency is a major reason why many businesses fail and consequently all stakeholders need to be aware of the liquidity position of businesses. Businesses that demonstrate an ability to manage their cash and other short-term assets are usually the most successful ones. There are two liquidity ratios preferred:-
1. Current Ratio
2. Quick Ratio
1. Current Ratio
The current ratio measures a company's ability to meet short-term obligations by using current assets. It is computed by dividing current assets by current liabilities. The larger the current ratio, the less difficulty a corporation should encounter in paying its current liabilities. Besides that, it also indicates how a business is performing in meeting its day to day commitments. A minimum figure of 1.0 would be considered the lowest limit that this figure should reach. Any business that has a current ratio near 1.0 may be heading for liquidity problems and would need to be closely monitored. It is expected for a business to be able to meet its current liabilities out of its current assets. Signs to look out for are increasing loans and bank overdrafts and bills being paid more slowly. Cash goes must always slow and cash come in must always fast. A figure greater than 2.0 would be more desirable to act as a buffer against any short term liquidity problems and give creditors a degree of comfort when granting credit or finance. Also if there is a healthy excess of current assets over current liabilities, then a company is in a better position to take advantage of any short term opportunities that may arise such as discounts and specials. On the other hand, too high a figure may indicate that a business is holding too much stock or has a poor credit control policy which usually means high amounts owing by customers or may not be making full use of its credit facilities. Below show the formula:-
Current Ratio =
2. Quick Ratio
The quick ratio sometimes called the acid-test ratio or liquidity ratio serves the same general purpose as the current ratio but excludes inventory from current assets because inventories are typically a firm’s least liquid current assets. Thus, the quick ratio measures a corporation’s ability to pay its current liabilities by converting its most liquid assets into cash. The ratio is calculated by dividing those assets which can be turned into cash almost immediately, by liabilities which have to be paid almost immediately. Similarly to current ratio, the higher the ratio, the better the liquidity position of a company. Box below show the formula:-
Liquidity Ratio =
A maximum time period of about three months gives you an idea of the use of this measure. The liquidity ratio indicates whether a business can meet its immediate obligations from cash, accounts receivable and other shorter term assets. Stocks are eliminated from this ratio because the sale of stocks could take a reasonable amount of time. Also, stocks may not realize their full value in the event of liquidation. It is useful to have a measure of the ability of a business to pay off short term obligations without relying on the sale of stocks. Hence, its quick ratio must be 1.0 or more. This is the reasoning behind the quick ratio standard of 1.0 that many analysts use as the dividing line between sufficient liquidity. Less then 1, would not expect to be able to pay its current liabilities by using only its quick assets.
2.3 Capital Structure Ratio
These ratios are also called the gearing ratios or leverage ratio. Generally, the main purpose is to assess the ability of a company in covering long term debt obligations. Basically, it measures the relationship between external debt funds, borrowings and the owners’ funds, equity. Of course the higher the debt compared to equity, the higher the leverage. Higher leverage or gearing means that creditors and bank managers may be less reluctant to deal with those companies, so every corporation must not highly geared as it can lead to bankruptcy. The ratios that we will look at under this heading are:-
1. Total Debt to Total Asset Ratio
2. Long Term Debt to Equity Ratio
3. Times Interest Earned
1. Total Debt to Total Asset Ratio
The total debt to total assets ratios measures the percentage of total funds provided by debt. Take note that this ratio also includes current liabilities as denominator because current liabilities are also a debt that company must bear. In general, the lower the percentage, the better as it shows the company is at stable level and manage to settle the small sum of debt. It is computed by dividing total liabilities by total assets. The percentage obtained indicates that the percentage a company owed and the rest shows the percentage of capital that invested by shareholders. For example, a figure of 40% means the percentage of debt is 40% and the balance is capital, money that provided by shareholders. Banks will determine in approving loans or not by looking the percentage of this ratio. If it is too high, banks will not supply loans and as a result the firms may not able to carry out plans that draft out. Despite that, suppliers are also concern on the ratio. Similarly to banks, dealing or not dealing with the company depend on the result. Hence, it is important that firm must not weight too much debt in hand as it can lead to insolvency. Formula will be given below:-
Total Debt to Total Asset Ratio =
2. Long Term Debt to Equity Ratio
The long term debt to equity ratio measures the proportion of long term financing sources to shareholders’ funds. It is computed by dividing long term debt by shareholders’ equity. Generally, the higher the ratio, the more financial leverage is employed by the firm, and the higher the financial risk whereas the lower this percentage goes the more safety margin for creditors of getting their money back if the company went into liquidation. Besides that, excessive percentage could affect any prudent lender for not extend loan finance to such businesses. The equity holders will also be threatened as much of the profit earned during the year will have a bigger portion used in interest payments leaving less returned profit for the shareholders. Companies must always monitor that long term debt must not exceed the equity. This is to assure the shareholders trust and creditors in keep supporting income to the company. The formula of this ratio is shown below:-
Long Term Debt to Equity Ratio =
3. Times Interest Earned
This ratio measures the ability of earnings before interest and tax to pay interest commitments. As for this ratio, poor result of times interest earned indicates the company is generating insufficient income to pay the interest. Basically, when a business is highly geared it will be paying more interest. Without fail, if a company has a low interest cover, for sure the gearing level is high. Like wise if the company has high interest cover, definitely the gearing level is at minimum. Debentures holders and other lenders to a company need to be sure that the profit before interest and tax adequately covers the interest payments. Interest must be paid even if a company makes loss, but it is reassuring if the profit before interest and tax covers the interest payment several times, a good cover provides a safety margin against a fall in profits in the future. Shareholders are also concerned to see a good interest cover as their dividends can only be paid if profit is left after charging the interest in income statement. It is computed by dividing earnings before interest and taxes by interest expense. Box below shows the formula:-
Times Interest Earned =
2.4 Asset Management Ratios
The asset management ratios are also sometimes called as efficiency ratios or working capital ratios. The aim is to measure how effectively a corporation manages its assets. If the company has too many assets, its cost of capital will be too high hence its profit depressed. On the other hand, if asset are too low, profitable sales will be lost. Briefly speaking, the higher ratio means the company is efficient in manage their assets. There are four ratios can diverse from asset management ratios:-
1. Average Collection Period
2. Inventory Turnover
3. Average Payment Period
4. Total Asset Turnover
1. Average Collection Period
The average collection period seeks to measure the average number of days it takes for a firm to collect its accounts receivable. The credit collection and collection policies of a business will determine the length of its collection period. If the company’s credit terms are monthly, meaning that average days outstanding are 45 days, the 42 days is a reasonable figure. But if the credit terms were supposed to be net 30 days after delivery, then the 42 days would not be so pleasing. Again, different industries have different expectations about this time period. For a large manufacturing company selling to other manufacturing companies, the average collection period would probably be about 45 days, as monthly terms are the norm. It would be pointless to compare the ratio of such a company with that of a retailer, whose collection period is less. A part from that, if receivables are excessively slow in being converted to cash, liquidity could be severely impaired. Besides, average collection period has also measurement problems. For example, when sales are made substantially but not entirely on credit, total sales are used in place of credit sales. Thus, the ratio calculated may not be accurate due to lack of information given. The average collection periods is calculated through dividing accounts receivable by credit sales and later multiply with number of days. Below indicate the formula:-
Average Collection Period =
2. Inventory Turnover
The inventory turnover measures the number of times per year that a corporation sells or turns over its inventory. It is computed by dividing the dollar amount of cost of sales by the dollar value of inventories. The quicker that stocks are sold, the better profitability and cash flow will be. In general, the high turnover ratio, the more efficient the business is in the producing-selling cycle. This is because the shorter the time that stock is held awaiting sale, the less will be stockholding costs. Excess stocks are unproductive, and very costly to store and administer. Cost of goods sold is used in the ratio because they valued at the same value as stock cost. Nonetheless, measurement problem is raised by the used of inventory in calculation. Since the purpose of this ratio is to measure the inventory turnover rate, the denominator should be a measure of the average amount of inventory that the corporation maintained during the year. However, in many cases the figure used for the denominator is the amount of inventory on hand at a particular point in time. If this figure is not representative of the average yearly inventory because of seasonal or cyclical production and selling patterns, for example, then the usefulness of this ratio becomes greatly limited. Therefore, average stocks is a better measure than a point-of-time stock value, as it eliminates any once-off peaks and troughs that might occur at the end of a period. Below show the formula to calculate this ratio:-
Inventory Turnover (days) =
or
Inventory Turnover (times) =
3. Average Payment Period
The average payment period measures how long it takes for an entity to settle its creditors in number of days. Usually the payable days should always be more than the receivable days due to the fact cash received from the customers will be used in settling the suppliers. So it is imperative that the company should always ensure than they secure more payable days than the days they allow their customers. Increase in payable days may indicate that the business is facing cash flow problems of not able to pay. Or it could be the existing suppliers that deal regularly may extend the credit term base on trust that affect the length of payable days to stretch. Of course, take longer to pay its creditors will be beneficial to its cash flow but it may be dangerous if it is greatly exceeding the period of credit allowed by suppliers as they may withdraw their credit facilities and require the company pay cash with orders in future which can influence the ratio to drop because abolishment of credit facilities. The ratio is derived by dividing creditors with purchases in days’ term. Below show the formula:-
Average Payment Period =
4. Total Asset Turnover
The total assets turnover ratio indicates how efficiently a firm is using all its assets to generate revenues. In simple phrasing, it measures the relationship between a dollar of sales and a dollar of assets, usually on a yearly basis. The calculation involves dividing sales by total assets less current liabilities. Generally, the higher the ratio, the more sales are achieved from the company's assets. Thus, if this ratio falls below expectations, then the business may have to investigate ways of improving asset utilization, either by increasing sales, or reducing assets or a combination of both. Apparently, this ratio helps to signal whether a firm is generating a sufficient volume of business for the size of its asset investment. Asset turnover is vague terminology, as it does not specify what assets are being referred to. It is necessary to state exactly what is to be included in the calculation. Amongst others, it could be total assets, fixed assets or net assets. Because asset values are point-in-time amount it would be wise to use an average figure, rather than an end of year figure. If an asset had been recently purchased and included in the ratio calculation it would distort the result. Below show the formula:-
Total Asset Turnover =
* Note: Total asset = Capital Employed
2.5 Market Value Ratios
Market value ratios shows the assess market price relative to assets or earnings. The term market price is the price at which people are willing to buy or sell the shares. Therefore, stakeholders are very keen on this aspect especially the potential shareholders. By looking in market value ratios, parties interested can also observe the market’s perception of the future earning power of the company. Basically, there are 5 ratios under this topic:-
1. Earnings per Share (EPS)
2. Dividend per Share
3. Dividend Yield
4. Dividend Cover
5. Price Earning (P/E) Ratio
1. Earnings per Share (EPS)
The earnings per share ratio express the profits per ordinary share earned by a corporation that will be distributed to ordinary shareholders. It is single most frequently analyzed and quoted financial ratio. This ratio is computed by dividing earning after taxes by the number of common shares authorized and outstanding. If the corporation also has preferred shares outstanding, preferred dividend are subtracted from earnings after taxes before converting to a per common share basis. This is because preference shareholders have the right to receive their dividend payment before ordinary shareholders. Many of the reasons why attention is focused on earnings per share rather than total earnings revolve around the corporate goal of shareholder wealth maximization as opposed to profit maximization. Generally speaking, the higher earnings per share will attract more investors to acquire shares in the company as it indicates that the business is more profitable enough to pay the dividends in time. But remember not all profit earned is going to be distributed as dividends the company also retains some profits for the business. Below derived the formula:-
Earnings per Share (EPS) =
2. Dividend per Share
The dividend per share ratio represents the dollar amount of cash dividends a corporation paid on each share of its common stock outstanding over a period of time. Ordinary shareholders are very interested in this figure as it tells them how much the return for the capital they put in. This ratio is derived by dividing total common stock dividends by the number of common shares outstanding. This procedure implicitly assumes that these shares were outstanding for entire 12 months. When the number of common shares outstanding changes significantly during the year, an average of the outstanding shares is used in computing per share financial ratios. Formula is shown below:-
Dividend per Share =
3. Dividend Yield
Dividend yield measures the real rate of return by comparing the dividend paid to the mark price of a share. As for dividend yield, the higher the ratio, the more directly earnings are distributed to owners and vice versa. No doubt high yield is good; the company needs to balance the dividend pay out and the retained profit. It may considered risky for a company even though obtaining high dividend yield because high dividend means large portion of profit will distributed back to shareholders and leaving less profit which is an important internal source of funds. This ratio is calculated by dividing dividend per share with market price per share in percentage form. Box below indicate the formula for dividend yield:-
Dividend Yield =
4. Dividend Cover
Dividend cover is the number of times the profit out of which dividends may be paid covers the dividend. High dividend cover indicates the company is making profits enough to sustain the payment of future dividends. The cover represents the security for the ordinary shareholders. On the other hand, if the cover is too low, a decline in profits may lead to the dividend being restricted or not paid at all. Retained profits are important sources of funds for most companies, and so the dividend cover can in some cases be high even though the firm is suffering loss. Reason is because changes in dividend cover may have a signaling effect to the shareholders and prospective investors. For instance, if a company’s dividend cover drops due to fallen profits, there is no choice for the directors but to pay the same amount of dividends as in previous year for the sake of fulfilling shareholders’ expectations on the particular company. Below shows the calculation method of dividend cover:-
Dividend Cover =
5. Price Earning (P/E) Ratio
The price earnings ratio is the relationship between how much investors are willing to pay for shares and how much they earn from shares. Generally, the demand for shares wills of course greater if the price earnings ratio is high. Apparently, this ratio can also measure the investors’ confidence in a company. Besides, it is also very useful when a company proposes an issue of new shares, in that it enables potential investors to better assess whether the expected future earnings make the share a worthwhile investment. The formula is generated by dividing market price per share with earnings per share as shown below:-
Price Earning (P/E) Ratio =
3. Limitations of the tool
Ratio analysis can provide useful information about the operations of a business and its financial condition. As was mentioned previously, ratios put numbers into perspective. They are part of the language of business, and managers must have a sound of knowledge of them. Not knowing them could be a sign that the business is not being properly managed. This makes it even more critical that people are fully aware of the limitations of ratio analysis. The main strength of ratios is their ability to be compared on like with like ratios of other companies. Therefore, understanding in limitations could help the misinterpretation.
1. Availability of information
Sometimes, denominator use in the calculation of ratios may be not accurate. Average collection period for example, that require amount of credit sales may be difficult to obtain because the sales value may not really indicate all the sales is on credit. Every debtors dealing business with a company for sure will have to pay certain deposit amount in order the credit sales will proceed. Thus, to be precise, company has to deduct cash sales out from the sales value to get real amount of credit sales.
2. Outdated information in financial statement
Ratios calculated are based on out historical information. That is why ratios might not give a proper indication of the company’s current financial position. Thus, ratios based on this information will not be very useful for decision making.
3. Different accounting practices
Different companies calculate items differently. For instance, there are various methods of stock valuations that can applied by companies. That is why ratios of a firm may not accurate when comparing with other that practices other method of stock valuation. Adjustment has to done to make ratio analysis meaningful. Management of a company should find out comparable statistics have been calculates and adjusting them in the appropriate manner to make them exactly comparable. Other than that, the method of depreciation, provision for doubtful debts and other accounting standard that differ must be taken seriously when come to comparing.
4. Window dressing
Every company wants to have good position of balance sheet so shareholders will keep stay and more money will flow in. Therefore, companies tend to hide the negative picture of them. Window dressing is a technique applied to show a strong financial position. In depth, in order to make financial statement look strong, a corporation may try to borrow a large sum of money a few days before the financial year end and pay the loan after the year end statement is done. By doing so, the current and quick ratios can improve which result balance sheet to be in good condition. However the improvement was strictly window dressing as a week later the balance sheet is at its old position.
5. Interpretation of the ratios
Basically, ratios cannot judge whether the business is weak or strong. This is because high ratios could have both negative and positive views. Like wise low ratios could also have both pros and cons. For example a high current ratio may indicate a strong liquidity position, which is good but at the mean time having excessive current assets could mean that the stock is not able to roll or the company is linen on collection period from debtors.
6. Economic factors
Financial analysts must be aware of economic factors that could cause the change in ratios figures. A company can be severely distorted when there is inflation. As a result, profits will be affected. Comparison over time results of ratios will lead to misinterpretation due to the factor of inflation that affects the levels of purchasing of power to differ. Of course, inflation has help in improved its performance and position but the fact after adjusting for inflationary changes it will show the different perspective. Thus a ratio analysis of one company over time must be interpreted with judgment.
7. Seasonal factors
Some businesses will be affected by seasonal factors. Consequently, it can influence ratio analysis. Thus, if a company business is depending on seasons, the managers should understand and analyze on this aspect to prevent misrepresentation of ratios. For example, a tobacco growing company will be able to show good results if accounts are produced in the selling season. Definitely, this time the business will have good inventory levels, receivables and bank balances will be at its highest. However, when come to planting seasons the company will have a lot of liabilities through the purchase of farm inputs, low cash balances and even nil receivables. Obviously, it can not judge a company by looking at the ratios as some businesses sales value fluctuates according to seasons.
8. Comparison between competitors
There would not be any two companies that are the same, even they are competitors from the same industry and what the company think it is best to take as best enemy for comparison. The truth is every business has different financial and business risk even may be within the same industry. Therefore, using ratios to compare one company with another could provide misleading information.
9. Creative accounting
Sometimes businesses apply creative accounting to reflects strong financial position so users are convince in their company is performing well but the fact it is not. The problem with this situation is that the directors may be able to manipulate the results through the changes in accounting policy. This would be done to avoid the effects of an old accounting policy or gain the effects of a new one. It is likely to be done in a sensitive period, perhaps when the business’s profits are low.
10. Inter-firm comparison
Trade associations typically collect information from every corporation to develop an industry average statistics for comparison. Bloomberg is a good source of general information industry where ratios per industry are provided for comparison. Unfortunately, the information provided by Bloomberg may include companies that actually operate different division even though the companies fall into the same categories. Take food and beverage ratio index for example, it will include firms that make prepared foods and some that are distributors. In this case, ratios would be distorted.
As a solution, it is better to apply cross-sectional analyses which mean select the companies that best fit to be compared. Other than that, selective application of government incentives to various companies may also distort inter-company comparison. One company may be given a tax holiday while the other is not given incentives by government. Comparing the performance of these two enterprises may be misleading.
4. Conclusion
Ratio analysis is a tool to evaluate company’s performance. It is therefore an essential tool in identifying the areas of weakness and strength of a company. When there are problems detected in a firm, immediate and wise action taken can help to solve it and eventually help company to improve. In short, financial ratio is a guide to a company. Nonetheless, ratios as stated above is meaningless on it own. They must be benchmarked against something so firms can get the rough concept whether their firms is improving or fall. Practically, ratios can be compared with others that help the firm in determine their current position in the market and thus urge them in improving. A part from that, ratios can be also used to analyze a corporation’s financial time series in order to discover trends, shift in trends and data outliners. Through this, company can observe their company performance and analyze the next step should be taken.
The various type of ratios used could actually help the firm in understanding the company’s operation even better. Profitability ratio for instant tells a company how much profits are generated. Besides, it did show the firm the trends it moving if comparison with previous years is done. Trends revealed can actually assist a firm to see whether there are moving upwards or downwards. If it is bad, firm can take action to change it to prevent any falling in the future. As for liquidity ratio indicates the position of liquidity of a firm and the ability of meeting short-term obligations. If the company is not liquid enough to convert current assets to cash, then the company may have trouble of facing bankruptcy. Basically, strong liquidity is better but it has to depend on other reasons as well because not necessary strong ratio is good. Capital structure ratio can also help company to check whether the company debts are overload. It is not good to have high ratio of debts because it will affect badly on funds of the company due to cut down of suppliers and shareholders capital. Consequently, firm may have to shut down due to insufficient capital. Furthermore, asset management ratios are a ratio that measures the efficiency of assets that being managed. Apparently, this ratio is more essential to the stakeholders especially customers and suppliers. Lastly, market value ratios give hints to the stakeholders of the performance of the company. Of course, it is vital to have good dividend and price earnings, so the shareholders will be satisfy and happy to keep their investment in the company. Generally, good ratio can attract even more potential shareholders to invest.
However, comparison may be imprecise due to ratios limitations. Problems exist as mentioned earlier, so people have to be caution on the weaknesses of the ratios. But if appropriate adjustments made on it could make the ratios figures obtained be more accurate. For instance, a decrease in the value of ratio does not necessarily mean that something undesirable has happened. With that, areas that cause the ratios to distort should be closely monitored. Attention on accounting standard, stock valuation, economic factors and others is a must to prevent the ratios figures obtained are misinterpretation. Thus, times in understanding the firm particular must be taken in order there is no misleading information existed. In conclusion, ratio analysis conducted in a mechanical, unthinking manner is dangerous. On the other hand, if used intelligently, ratio analysis can provide insightful information.
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