Financial statements published by companies are their way of communicating with the outside world about both the performance and position of the company. While accounting regulates that information should be truthful, reliable, a fair representation, complete and material there are very few things that do not possess room for improvement. Ratio analysis is used by many analysts and other users of financial statements to go deeper into the information presented in financial statements. The objectives of ratio analysis vary depending on the user of the financial statements and the ratios they are calculating.
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What Is Ratio Analysis?
Ratio analysis is a quantitative method of gaining insight into a company’s liquidity, operational efficiency, and profitability by studying its financial statements such as the balance sheet and income statement. Ratio analysis is a cornerstone of fundamental equity analysis. In ratio analysis users combine information from different parts of the financial statements to derive measures which give a deeper understanding of a certain aspect of the company or business in question. The objective of ratio analysis is to process financial statement information to give it meaning.
Everybody understands the concept of net income which is calculated by subtracting operating expenses from operating revenue. The bigger the number the better. However, a potential investor would want a deeper understanding of the profit. The potential investor’s objective of ratio analysis would be to determine how well they performed compared to resources available. How much capital was employed to bring the level of income? Two different companies both with a profit of 1 million have certainly done well. But if the first company had capital of 10 million while the second had capital of 100 million the Return on Capital Employed for each company would be 10% and 1% respectively. An investor would prefer to have his capital employed with the first company. Now that we understand what ratio analysis is we can look at the objectives of ratio analysis.
As illustrated in the earlier example one of the objectives of ratio analysis is the determination of profitability. There is an entire group of ratios which determine the profitability of a company. Examples of ratios in this group are Return on Equity, Return on Assets and net profit margin. Many different groups of users would have their own reasons to look at a companies profitability. Current and potential investors would certainly be interested in the long term prospects of the business. Employees and creditors would be interested too as it gives an idea of how well the company’s prospects look going forward.
Determine Operational Efficiency
Operational efficiency is another important indicator of how well company management is doing and another objective of ratio analysis. Operational efficiency is a measure of how well the resources within a company were used. Efficiency ratios differ from profitability ratios in that they look at the operations of the company and not the profit churned out. An example is the rate of inventory turnover which looks at how many times in a year a company managed to completely sell out inventory. The more times the better as it indicates they are moving inventory faster and turning investment in inventory into profit faster. Management would be interested in this figure as would competitors in the market.
The solvency of a company can be important to many stakeholders. Solvency simply speaks to the ability of a business to meet its long term financial obligations. It’s commonplace in modern business to use methods of debt financing or borrowing outright to fund business operations. Of course, lenders would prefer to lend, especially long term to businesses which are capable of meeting obligations in the future. If a company were to apply for a bank loan, the bank might look at the businesses Interest Cover, which measures how many times the net profit outweighs their current interest obligations. This gives a measure of how much debt they can take on. The objectives of ratio analysis include assessing the solvency of a company. Solvency may also be of interest to employees, investors, creditors and competitors.
Liquidity is a term referring to the ability of a company to meet its short term obligations such as accounts payable. The objectives of ratio analysis include assessing the liquidity of a company. A supplier extending trade credit to a company would be interested in the ability of the company to pay trade creditors. One measure used to assess the liquidity of a company is the Current ratio which compares the value of current assets, because they can be converted to cash quickly, to current liabilities to see if a company has enough current assets to pay for its current liabilities.
Better Financial Analysis
For publicly traded companies analysts will always look at the companies as an investment. There are many different investment valuation measures and techniques but the guiding principle is that the value of an asset (in this case a share in a company) is the discounted value of its expected future cash flows. Simply put today’s price should reflect what we expect to get from the share in the future. The objectives of ratio analysis include evaluating whether the market price of company shares is worth it. The most popular of these price ratios is the Price Earnings ratio which divides the market price of a share by the earnings per share to evaluate how much one would pay to get one dollar of earnings from the company. This ratio analysis objective is the most prominent with analysts and includes other ratios such as dividend yield and price to book value.
Another ratio analysis objective we can look at is assessing the financial strength of a company. There are many ratios that illustrate this objective of ratio analysis but the best to illustrate this is the debt to equity ratio. This ratio compares the amount of debt finance a company uses to the total equity a company has. The degree to which a company borrows is also known as gearing. When debt exceeds equity (negative gearing) a company has a very expensive cost of capital because debt has mandatory interest payments where equity does not, a dividend is optional.
Finally, we can look at forecasting as an objective of ratio analysis. Many groups of users would attempt to forecast the future performance of a company. Investors may be interested in the ability of a company to organically grow. They would apply the Internal Growth Rate, a ratio that looks at what percentage of profit a company retains and how well it utilises assets because retained earnings are assets. This would give the analyst or user an idea of the ability of the company to keep growing from internal capital sources.
In conclusion, the objectives of ratio analysis depend on the specific user. We have identified measuring profitability, operational efficiency, solvency, liquidity, financial strength, financial analysis and forecasting as distinct ratio analysis objectives.