Understanding Financial Ratio Analysis

Sep 18, 2024

Financial Ratio Analysis

Introduction

  • Presenter: Derek
  • Focus: Financial ratio analysis to analyze and monitor a firm's performance.
  • Management aims to produce favorable financial ratios for owners and creditors.
  • Comparing ratios provides more objective insights than just comparing figures from financial statements.

Example of Profit Comparison

  • Company A: Net profit = $100,000

  • Company B: Net profit = $10,000

  • Sales:

    • Company A: $1,000,000
    • Company B: $20,000

  • Profit Margin Calculation:

    • Company A Profit Margin = 10%
    • Company B Profit Margin = 50%

  • Conclusion: Company B is more efficient despite lower sales.

Types of Ratio Comparisons

  1. Trend Analysis (Time Series Analysis):
    • Evaluates performance over time.
  2. Cross-Sectional Analysis:
    • Compares firms at the same point in time.
    • Industry Comparative Analysis: Firm performance vs. industry average.
    • Benchmarking: Firm performance vs. industry leader or key competitor.

Categories of Financial Ratios

  1. Liquidity Ratios:

    • Measure the ability to meet maturing obligations.

    • Current Ratio: Current Assets / Current Liabilities

    • Acid Test Ratio (Quick Ratio): (Current Assets - Inventories) / Current Liabilities

    • Interpretation:

      • Current ratio above industry average indicates lower risk.
      • High current ratio could indicate excess inventory.

  2. Activity Ratios (Efficiency/Asset Management):

    • Accounts Receivable Turnover: Credit Sales / Accounts Receivable
    • Average Collection Period: Accounts Receivable / Credit Sales * 365
    • Accounts Payable Turnover: Credit Purchases / Accounts Payable
    • Average Payment Period: Accounts Payable / Credit Purchases * 365
    • Inventory Turnover: Cost of Goods Sold / Average Inventory
    • Fixed Assets Turnover: Sales / Net Fixed Assets

  3. Debt Ratios (Leverage Ratios):

    • Measure financial leverage.
    • Debt Ratio: Total Debt / Total Assets
    • Debt to Equity Ratio: Total Debt / Common Equity
    • Times Interest Earned: EBIT / Interest Expense

  4. Profitability Ratios:

    • Measure ability to generate profits.
    • Gross Profit Margin: (Sales - COGS) / Sales
    • Operating Profit Margin: Operating Income / Sales
    • Net Profit Margin: (Net Income - Preferred Dividends) / Sales
    • Return on Assets (ROA): Net Income / Total Assets
    • Return on Equity (ROE): Net Income / Common Equity
    • Earnings per Share (EPS): Earnings Available to Stockholders / Outstanding Shares

  5. Market Value Ratios:

    • Assess firm's performance as perceived by the market.
    • Price to Earnings (P/E) Ratio: Market Price per Share / Earnings per Share
    • Price to Book (PB) Ratio: Market Price per Share / Book Value per Share

Limitations of Financial Ratio Analysis

  • Different accounting policies (e.g., depreciation methods) can distort comparisons.
  • Different accounting year-ends may affect ratio values.
  • Inflation is not accounted for, impacting real revenue assessment.
  • Year-end figures may not represent overall annual performance.
  • Information is often outdated, limiting real-time analysis.
  • Ratios are guides, not definitive measures.

Conclusion

  • Financial ratios provide valuable insights but should be used with other analysis tools.
  • Be cautious of different methods of calculation across firms.

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