ISL459U-FINANCIAL STATEMENT ANALYSIS
Chapter 5: Ratio Analysis
The Content and Importance of Ratio Analysis
Ratio analysis is an evaluation technique that identifies key relationships among the selected items of financial statements.
Since the ratio is a mathematical expression between one quantity and another it is necessary to know what the calculated result represents in the ratio analysis. The results can indicate meanings such as "day", "times", and "percentage" according to the items discussed. Since the ratios show only the relationship between items, the reasons for the relationship depend on the analyst's accounting knowledge, industry knowledge and experience.
In financial analysis, any of the analysis technique alone can provide all the information about the business Similarly, using only one ratio will not provide sufficient information to make decision. For example, it will not be sufficient to calculate a ratio only on the totals of current assets and short-term liabilities to obtain information about the liquidity of the business. Using additional ratios that deepen this information and even supporting this information will enable the analysis to achieve the desired goals.
Another important point in ratio analysis is to consider the effects of the values in the numerator and the denominator. Beside the internal operating activities that affect a company’s ratios, we must have knowledge of the effects of economic events, industry characteristics, management policies, and accounting methods. The changes in the accounting policies of the company over the years or the differences caused by the companies operating in the same industry following different accounting policies, and the effect of inflation on the items in the financial statements will also affect the analysis results.
The usefulness of ratios depends on the reliability of the numbers. When a company’s internal accounting controls or other governance and monitoring systems are not reliable in producing reliable figures, the resulting ratios will equally be less reliable.
Ratios are usefully interpreted in comparison with prior ratios, predetermined standards, ratios of competitors and industry averages.
Many meaningful ratios can be calculated from the financial statements. However, the ratios that will emerge in large numbers have been subjected to various classifications due to their usefulness and ease of comparison.
Liquidity Ratios
Current assets, also known as gross working capital, have two main functions. These are;
• Payment of overdue short-term liabilities and • Ensuring that daily transactions are carried out.
Liquidity is expressed as an indicator of the quality and adequacy of current assets in order to meet the short-term financial obligations. Therefore, the liquidity ratios are used
to measure the short-term debt paying ability of the business and to determine whether the net working capital is sufficient.
Net Working capital is current assets minus current liabilities and it is defined as follows:
Net Working Capital = Current Assets - Current Liabilities
Payment of short-term debts is important for both the borrower and the creditor. Liquidity ratios are important in order for the business to continue its activities and to evaluate whether creditors can collect their receivables. In recent times, we hear on the news that businesses having millions of dollars of assets have gone bankrupt. One of the underlying factors of this situation is that short-term debt due is not paid. From this point, we can say that liquidity ratios consist of current assets items as well as short term liabilities items.
Liquidity ratios are used to measure the short-term debt paying ability of the business and to determine whether the net working capital is sufficient.
Current Ratio
The current ratio is calculated as the current assets divided by short-term liabilities (current liabilities). The expression “current ratio” comes from the relation between two “current” values as you notice. It is used to measure the entity's ability to pay short-term debts and to determine whether net working capital is sufficient. It gives a general view because it is calculated by considering group totals rather than the composition of current assets and short-term liabilities, but it is widely used in financial analysis.
Current Ratio = (Current Assets) / (Current Liabilities)
If the current ratio is 1.88, the alternative means of expression are as follows:
• Current assets are 188% of current liabilities. • Current assets are 1.88 times current liabilities. • The relationship of current assets to liabilities is 1.88:1
A high current ratio indicates that the business has sufficient current assets to maintain normal business operations.
Acid-Test Ratio (Quick Ratio)
Acid-test ratio (quick ratio) is important in terms of interpretation of the current ratio in a more sensitive way. Acid-test ratio provides a more stringent measurement about liquidity compared to the current ratio. Because the current ratio does not consider the composition of the current assets.
The acid-test ratio is a measure of a company’s immediate liquidity.
Numerator of the acid-test ratio eliminates inventory because inventory is the least-liquid current assets. The inventory may not be readily saleable. To calculate this ratio:
(Current Assets-Inventories) / (Current Liabilities)
It is assumed that the result of the acid-test ratio should be “1”. Such a result shows that all the short-term liabilities can be paid with cash, short-term investments, and accounts receivables. In other words, the ratio of 1 means that for every 1 Lira of short-term liabilities company has 1 Lira of current asset minus inventories. However, in the evaluation of the result, the collectability of the receivables and the salability of the inventories should also be taken into consideration.
Even the result is 1, when the company has problems to collect its receivables, the liquidity structure may not be good. On the contrary, when the result is less than 1, it may be accepted that it will cause negative interpretation at first glance, but the high rate of conversion of inventories into cash can eliminate this negativity. If the acid-test ratio is less than 1, the analysis is strengthened by measuring the dependence of the company on the inventories in the payment of short-term debts.
Cash Ratio
The cash ratio reflects the short-term debt paying ability of the company in a more sensitive way. The cash ratio shows a company's ability to cover its short-term obligations with only cash and cash equivalents. Therefore, in calculating the cash ratio, receivables and inventories will be subtracted from total current assets. The cash ratio can be formulated as follows;
(Cash and Cash Equivalents) / (Current Liabilities)
It is generally accepted that the cash ratio should be between 0.20 and 1. A cash ratio equal to 1 shows that the company has 1 lira worth of short-term liabilities in return. In other words, it means that the company can pay all of its short-term debts with its cash and cash equivalent assets. Such a high liquid structure might signify that the company has an unnecessarily large amount of cash supply. This cash could be used to invest in profitable projects or be distributed as dividends to stockholders.
Ratio of Inventories to Net Working Capital
The ratio of inventories to net working capital shows how much of net working capital is tied to inventories. Since the net working capital is used to maintain the daily activities of the company, it can be said that if this ratio is high, the net working capital is highly tied to the inventories, so that the execution of the daily activities can be realized by selling the inventories. The ratio of inventories to net working capital is expressed as “percentage” and calculated as follows;
Inventories / (Net Working Capital) × 100=%
Financial Structure Ratios (Solvency Ratios)
Financial structure (solvency) ratios are important in terms of revealing the structure of financing activity. Financial structure ratios can answer questions such as the assurance status of the business in terms of creditors, the balance between liabilities and equities, how the assets are
financed, and the effect of borrowing on business profitability. Those ratios measure the ability of a company to meet its long-term financial obligations and to survive over a long period of time.
Debt Ratio
Debt ratio shows the proportion of all assets that are financed with debt. This ratio is calculated by dividing total liabilities by total assets.
(Total Liabilities) / (Total Assets) × 100 = %
If the debt ratio is 100%, then all the assets are financed with debt. If the result is equal to 50%, it means that half of the assets are financed with debt, and the other half are financed by the equity. Higher debt ratio gives a narrow margin of safety for the lenders, because of the risk of the company's inability to collect receivables in case of liquidation. The higher the debt ratio, the higher the company’s financial risk.
Short Term Liabilities to Total Sources Ratio
Short Term Liabilities to Total Sources Ratio shows the proportion of assets are financed with short-term liabilities.
(Current Liabilities) / (Total Assets) × 100 = %
The point to be considered here is the maturity compliance issue. Maturity compliance principle indicates that current liabilities must only finance the current assets, while the non-current assets should be financed by owners’ equity and long-term liabilities.
Debt to Equity Ratio
Debt to equity ratio provides a different perspective on the manner in which a company funds its assets as with the debt ratio, it shows the relative proportion of equity and debt used to finance a company's assets. This ratio can be used to evaluate how much leverage a company is using. It measures the riskiness of the firm’s capital structure in terms of the relationship between the funds supplied by creditors (debt) and investors (equity). Debt to Equity Ratio Formula:
(Total Liabilities) / (Total Equity)
If the debt to equity ratio is greater than 1, then the company is financing more assets with debt than with equity. If the ratio is less than 1, then the company is financing more assets with equity than with debt.
Non-Current Assets to Equity Ratio
Non-Current Assets to Equity Ratio shows the proportion of non-current assets are financed with equity and is calculated by dividing total Non-Current Assets by total equity.
(Non-Current Assets, net) / (Owners^' Equity) × 100 = %
If the result is below 100%, it indicates that equity is sufficient in financing the non-current assets of the company.
Non-Current Assets to Continuous Capital Ratio
Continuous capital is the sum of owners’ equity and long- term liabilities. The ratio of non-current assets to continuous capital is calculated by dividing the total of non-current assets by continuous capital, which is the amount expected to finance it.
(Non-Current Assets) / (Continuous Capital) × 100 = %
Continuous Capital = (Owners' Equity + Long-Term Liabilities)
In the financing of non-current assets, companies primarily use owners’ equity. If owners’ equity is not sufficient, they use long-term liabilities. Short-term liabilities should not finance non-current assets as they will result in maturity mismatch.
Times Interest Earned (Interest Coverage) Ratio
The times interest earned (interest coverage) ratio is important to evaluate the company’s ability to meet interest payments as they come due. It indicates how well operating earnings cover fixed interest expenses. In order to talk about the successful use of liabilities, the profit of the company should be higher than the interest expenses. The fact that this ratio should be high and a high ratio indicates a business’s ease in paying interest. Conversely, a low ratio indicates that a company has a higher chance of difficulty.
This ratio measures how many times company can make interest payment. The formula for times interest earned ratio is earnings before interest and taxes (EBIT) divided by the total interest expense as follows;
EBIT / (Interest Expense) = Times
Activity Ratios (Efficiency Ratios)
Assets are defined as the economic resources which are acquired to use in the operations of the company. Is the business able to use these assets efficiently? The operating cycle is one of the important indicators of efficiency, which indicates the process of cash investing in inventories, selling of inventories and accounts receivables (with credit sales). In case of cash sales, inventories sold will be converted into cash directly and receivables will be collected and converted into cash again. Considering the aim of the business to make profit, completing the process for one time means making profit related to the main activity. Therefore, the more completion of the cycle in one operating period, the more efficient it will be to use the operating assets and increase the profitability.
Activity ratios are used for measuring the efficiency of the assets and also supports measuring the liquidity of the business.
Inventory Turnover Ratio
Inventory turnover ratio measures the number of times a company sells its average level of merchandise inventory
during a period. Its purpose is to measure the liquidity of the inventory.
The largest share in the inventory items of the commercial companies is the Merchandise Inventory purchased for sale. Therefore, the inventory turnover ratio shows how long the inventory is subject to sale. To compute inventory turnover, we divide cost of goods sold by the average inventory.
(Cost of Goods Sold) / (Average Merhandise Inventory)
The high inventory turnover ratio is an indicator of the possibility of increasing the profitability of the company. Because it may have compromised profitability to increase business sales, or operating expenses and other costs may have increased due to efforts to increase sales. In cases where other conditions are the same, the company with higher inventory turnover than other companies have more competitive power.
The high inventory turnover ratio indicates that the company can quickly dispose of its inventories, thus it will be less affected by the negativities that may arise from holding inventories, technological developments and developments that will negatively affect the business, such as the commodity going out of fashion.
Days in Inventory: The inventory turnover ratio shows how many times the inventories of the business are subject to sales during the year. By dividing the result with the number of days in the year, the ratio of inventory period, which indicates how many days it takes before the inventory is sold, can be calculated.
Accounts Receivables Turnover Ratio
The turnover ratio of accounts receivables is calculated by dividing the amount of credit sales in a certain period by the average account receivables.
(Credit Sales)/(Average net Accounts Receivable)=Times
Since account receivables are result of credit sales, it is a correct approach to include the amount of credit sales in the numerator of the ratio. However, it may not always be possible to know the amount of credit sales. In such cases, net sales amount can also be used instead of the amount of credit sales.
(Net Sales)/(Average net Accounts Receivable)=Times
The amount of accounts receivable, which are in the denominator of the ratio, should be used as net amount.
The high accounts receivable turnover ratio indicates that the company can easily collect its receivables during the year. This is very important in terms of demonstrating that receivables can be collected t and then showing that the business can quickly complete its operating cycle and make a positive contribution to its profitability. The low receivable turnover ratio may be an indication that there may be problems in the collection of receivables,
weakness of competitiveness and not being very flexible about credit sales.
Average Collection Period: Another ratio that makes the accounts receivable turnover significant is the average collection period ratio. This ratio is expressed in terms of "days", how many days it takes to collect the average level of receivables.
360/(Accounts Receivables Turnover)=Days
Net Working Capital Turnover Ratio
The net working capital turnover ratio is calculated to determine how efficiently the net working capital is used.
(Net Sales)/(Average Net Working Capital)=Times
The high ratio result may be an indication that the turnover ratios for inventories and receivables are high and that inventories and receivables need relatively little working capital or that net working capital is insufficient. In addition, a high result is an indicator of efficiency. Since efficiency has a positive meaning with profitability, it should be interpreted by considering profitability.
Current Assets Turnover Ratio
The turnover ratio of current assets shows how many times of sales revenue is provided according to current assets. High turnover ratio is an indicator of efficiency or insufficiency of current assets. Otherwise, it can be thought that the entity does not use its current assets efficiently or has more than enough assets. In this case, the business profitability will be impacted negatively.
Property, Plant and Equipment Turnover Ratio
The property, plant and equipment turnover ratio is used to measure the degree of investment of the company in property, plant and equipment. Whether the investment in property, plant and equipment is excessive or not, the existence of idle capacity or whether the property, plant and equipment are working on their capacity can be determined by interpreting this ratio. The fact that the result is below 1 indicates that the property, plant and equipment do not contribute to the sales even as much as their amount. The high result may be an indication that assets are used above their capacities.
Total Assets Turnover Ratio
The asset turnover ratio is used to measure the efficiency of the assets of the business. A high asset turnover ratio is an indication that the assets of the company are used efficiently with full capacity. If the ratio is low, it can be said that the company has idle capacity, and therefore the efficiency is low.
Owners’ Equity Turnover Ratio
Equity turnover ratio shows how efficiently the equities are used. The high ratio indicates that equities are used economically and efficiently. However, the fact that the ratio is higher than normal is an indicator that the amount of the equity is insufficient and that the weight of the
assets is in liabilities in financing the assets. The fact that the ratio is far below normal indicates that a very large amount of equity is used in financing the assets.
Profitability Ratios
The main purpose of businesses is to make a profit. Profit is the positive difference between income earned in a certain period and expenses incurred in the same period. However, it is not enough to know just how big the profit is. Knowing the income and expenses both in terms of amount and variety will provide the necessary information for the execution of the activities.
Profitability ratios are used to determine whether the expressed profit amounts are sufficient. Business owners will also want to know the return on the capital they invest in the business. Therefore, it is important to know the return of sales, as well as the return of assets and equity. Based on this point, it is possible to divide profitability ratios into two main sections. These are;
• Ratios showing the relationship between Profit and Sales, • Ratios that show the relationships between profit and Capital
Ratios Showing Relationships Between Profit and Sales
The results of the entity's main activities and other activities are reported in the income statement. The income statement is also arranged to provide information regarding the main activities and the other activities. Accordingly, the income statement consists of five segments as Gross Sales Profit section, Operating Profit section, Profit from Other Operations, Period Profit section and Net Period Profit section.
• Gross Profit Margin Ratio: shows what percentage of net sales remain in the business as gross profit. • Operating Profit Margin ratio: This ratio provides information regarding the profitability of the operating volume of the business shows the extent of the company's main business is profitable. Since it is a ratio related to the main activity, it is interpreted positively that it is high and has an upward trend over the years. • Net Profit Margin Ratio: Net profit margin ratio shows the profit earned for every 1 lira of net sales. As the net profit for the period expresses the profit after tax, it is an indicator of the result of all the activities of the business. A high result is interpreted in favor of the business, taken together with satisfactory efficiency.
Ratios Showing Relationships Between Profit and Capital
The main purpose of businesses is to make a profit. It is necessary to relate the profit with equity and long-term liabilities whether they are used efficiently. For this purpose, the relations between equities and investments
using liabilities and the income from these investments are examined.
• Return on Equity (Financial Profitability) Ratio: shows what percentage of net sales remain in the business as gross profit. Return on Equity (ROE) reflects the ratio of profit per unit of capital invested in the company. (Net Profit)/(Average Owners' Equity) × 100=% • Amortization of Continuous Capital ratio: is used to measure the return on the continuous capital which is the sum of equity and long-term liabilities. It shows that the company earned a profit of up to % percent of the total resources. The high ratio is an indicator that the resources are used profitably.
Profitability Ratio of Total Assets (Return on Assets)
Return on Assets ratio (ROA) shows how efficiently the assets are used in the company. It finances its operating assets through equity and liabilities, if any. However, by using this ratio, it will not be possible to determine from which liability source the entity finances its assets.
(Net Profit)/(Average Total Assets) × 100=%
In a company that finances its assets predominantly with liabilities, this ratio will be lower than that of the that mainly uses equity in asset financing.
The profitability ratio of the assets can also be calculated by relating the net profitability of the business and the ratio of turnover of the assets. Thus, the effect of the net profitability of the company and the turnover ratio of the assets on the profitability of the assets can also be examined.
(Net Profit)/(Net Sales) × (Net Sales)/(Average Total Assets)=(Net Profit)/(Average Total Assets)
Based on this equation, the net profitability of the company and the turnover ratio of the assets should increase in order to increase the profitability ratio of the assets.