Introduction
Financial ratios are a quick and very simple method to shine a lens on a business and assess its financial health or at least raise questions to be asked. Financials can be analysed by staff, management, shareholders and lenders to assess the organisation’s health. They can also be used for staff performance such as days for collection of accounts receivable, inventory turnover and accounts being paid. Profit performance is also relevant and all of these ratios can be compared to industry standards or competitors if their information is available.
Common Sized Financials
It is impractical to compare the financials of a large corporate to a small business. The variances are too great. As a result, the principle known as Common Sized Financials is used. In order to create a Common Sized Income Statement, all of the figures in the Income Statement are divided by the Sale to give a percentage. For the Balance Sheet, each entry in the report by the organisation’s total assets. Once this has been done, organisations can be compared irrespective of size.
Financial Ratios
Another form of analysing an organisation is by use of financial ratios. These are standard mathematical results of combining and dividing some figures from the accounts.
Financial statements and ratios
Ratios can effectively be presented in two methods:-
- Trend or Horizontal analysis when looking at the performance of an organisation over a period of time.
- Peer or Vertical analysis when looking at comparing the performance of an organisation with others
Ratio Categories
Financial ratios, which measure an organisation’s performance, can be divided into a number of categories.
| Type | Description |
|---|---|
| Profitability | The ability of an organisation to make a profit and return on assets |
| Liquidity | Ability to meet short term liabilities from current assets |
| Efficiency | The efficiency of the organisation in generating a return |
| Leverage | The amount of debt compared to equity |
| Market Value | Performance of organisation based on stock market matrices |
Profitability ratios
Profitability can be assessed in a number of ways. Some organisations use net profit, others net profit after tax and others earnings before interest and tax. All three are valid measurements depending on what you are looking at or comparing at the time. For example, a highly geared company may have the same net profit before interest as a low geared company, but both would be different after interest was taken into account.
Gross Profit Ratio
$$ Gross\ Profit\ Ratio\ =\ \frac{Gross\ Profit\ Amount}{Sales}$$
Net Profit Ratio
$$ Net\ Profit\ Ratio\ =\ \frac{Net Profit}{Sales}$$
Return on Assets
$$ Return\ On\ Assets\ =\ \frac{Operating\ Profit\ or\ EBIT}{Total\ Assets}$$
Liquidity Ratios
Liquidity ratios measure if the organisation has sufficient cash and convertible current assets to meet its short-term liabilities. These ratios also look at how quickly an organisation collects its receivables and turns over its stock.
1. Analysing measures of overall liquidity
Two ratios look at the overall liquidity of an organisation.
Current Ratio
$$ Current\ Ratio\ =\ \frac{Current\ Assets}{Current\ Liabilities}$$
Measures the ability of an organisation to meet its short term liabilities. Ideally should be above 1:1
Quick Ratio or Acid Test
$$ Quick\ Ratio\ =\ \frac{Current\ Assets\ -\ Inventory}{Current\ Liabilities}$$
Measures the ability of an organisation to meet its short-term liabilities without having to convert its inventory to cash. Some organisations turn their inventory over much more slowly than others. For example, a supermarket compared to a heavy machinery dealership.
2. Measuring the liquidity of individual assets
The first of these ratios is the average collection ratio which measures the number of days on average that an organisation takes to get its account paid by its debtors.
Average Collection Ratio
$$ Average\ Collection\ Ratio\ =\ \frac{Debtors }{(Annual\ Credit\ Sales\ /\ 365)}$$
Some organisations are very good at collecting their accounts as they refuse further credit if monies are outstanding. Professionals on the other hand often have very poor collection periods.
Alternatively, you can use the ratio of $$ \frac{Annual\ Credit\ Sales}{Accounts\ Receivable}$$ to establish how many times an organisation is turning over its debtors. I prefer the number of days measurement.
Inventory Turnover or Stock Turn Ratio
$$ Inventory\ Turnover\ or\ Stock\ Turn\ Ratio\ =\ \frac{Cost\ of\ Goods\ Sold}{Inventory}$$
This ratio will tell you the number of days on average that it takes the organisation to turn over their stock. The shorter the period the bettern as stock ties up cash.
All of the above ratios are known as “Working Capital Ratios”.
Efficiency ratios
Asset efficiency ratios are used to establish whether assets are being used efficiently in the generation of sales for the organisation.
Asset Turnover Ratio
$$ Asset\ Turnover\ Ratio\ =\ \frac{Sales}{Total\ Assets}$$
Fixed Asset Turnover Ratio
$$ Fixed\ Asset\ Turnover\ =\ \frac{Sales}{Fixed\ Assets}$$
Different organisations will have their own measures of efficiency. A call centre will want to measure the number of calls and the time taken to resolve. A not-for-profit may measure the number of people helped. A mine may measure the amount of ore extracted daily. All are valid measurements if meaningful to the organisation.
Leverage ratios
Capital ratios or gearing ratios measure the level of debt an organisation has compared to equity.
Debt or Gearing Ratio
$$ Debt\ Gearing\ Ratio\ =\ \frac {Total\ Liabilities}{Total\ Assets}$$
Interest Coverage Ratio
$$ Interest\ Coverage\ Ratio\ =\ \frac{Operating\ Profit\ or\ EBIT}{Interest\ Expense}$$
This ratio measures the number of times over an organisation can pay its interest on debt. For this reason, I prefer to use EBIT as the figure instead of profit.
Market value ratios
These ratios look at how a company’s shares are valued on the stock market. These are not based on accounting values, but on share prices.
Price Earnings P/E Ratio
This ratio shows the amount an investor is willing to pay for every dollar a company earns.
$$ Price\ Earnings\ P/E\ Ratio\ =\ \frac{Market\ Price\ per\ Share}{Earnings\ per\ Share}$$
Earnings per share is the profit of the company divided by the number of ordinary shares issued.
Market to Book Value
This ratio measures the market value of each share compared to the book value of a company’s shares.
$$ Market\ to\ Book\ Value\ =\ \frac{Market\ Price\ per\ Share}{Book\ Value\ per\ Share}$$
The Book Value per share is calculated as follows:
$$ \frac{Total\ Assets}{Number\ of\ Ordinary\ Shares\ issued}$$
The DuPont method
When you take the profit of an organisation and divide it by the equity, the result is the Return on Equity. One way of gaining a greater understanding of what is driving the return on equity however is the Du Pont method. Essentially, the Du Pont method breaks the Return on Equity down into three components.
- Net profit margin $$\frac{Net\ profit}{Ordinary\ Equity}$$
- Total asset turnover $$\frac{Total\ Sales}{Total\ Assets}$$
- Financial leverage $$\frac{Total\ Assets}{Ordinary\ Equity}$$
The Full Formula is as follows:-
$$ {Net\ Profit\ Margin}\ x\ {Total\ Asset\ Turnover}\\x\ {Financial\ Leverage}\ x\ {Equity\ Multiplier}$$
The equity multiplier is calculated by $$ \frac{Total\ Assets}{Ordinary Equity}$$
By looking at each of these aspects of an organisation’s financials, we can find what may be the biggest driver of its returns or why it departs from industry standards. The video below looks at the breakdown of the Du Pont method and how various results are determined from the ratios.
Limitations of ratio analysis
Ratio analysis is not the be-all and end-all of analysing an organisation but rather signposts of what may need further investigation. Some of the factors affecting ratio analysis are:-
- It can sometimes be difficult to identify which industry an organisation belongs to when they trade across many different spectrums.
- Accounting policies between organisations can affect comparisons
- Industry averages are just that, averages and cannot always be relied upon
- Organisations can experience different trading issues over time that need to be accounted for
- Some organisations operate seasonally so ratios can distort results
- The results of ratio analysis will always depend on the presentation of the financial accounts. (For example, some accountants do not split the current and non-current portion of the debt, particularly in Small and Medium Enterprises. This can result in considerable distortion of the current ratio and quick ratio.)
Assessment 1
The first assessment is due on the 20th September and involves comparative analysis of two public companies as mentioned in the previous post. With this module completed, it is time to begin working on the assessment. I have always found it interesting working with figures and ratio analysis and I am looking forward to this assessment. My personal experience has been in SMEs, so analysing public companies will be somewhat different.
Summary
This module has examined the ratio analysis of financial statements in considerable detail. While the calculations are not difficult, it is the understanding of the results that are essential to a quality assessment. With this module now complete, it completes the study of the first three modules which are required for the completion of the first assessment.
As a side benefit, I have learned about LaTex and how to write formulae in both Obsidian, the markdown editor I use for note taking and my PKM system and then convert to WordPress.
This will be my final post from the road. We have been travelling for the last 3 months in our caravan and at times connecting for lectures and study has been challenging. Nonetheless, it has been an enjoyable time away. I am now looking forward to having all my computing power and multiple screens back in front of me at home.
References- The summary of this module is based on the study notes provided by the Australian Institute of Business Module 3 Financial analysis: Introduction to financial analysis using ratios 2022, Aib.edu.au, viewed 11 September 2022, <https://learning.aib.edu.au/mod/book/view.php?id=113084&chapterid=41259>.[↩]
