When you pick up the published accounts of a company for the first time, it can be an intimidating experience as you are faced by page after page of numbers. Financial ratios provide you with the tools you need to interpret and understand such accounts. They are essential if you want to look in detail at a company's performance.
As the financial reports of a business contain a wealth of financial information, it is important to consider why we are analyzing and interpreting the financial reports. The users of financial reports are wide ranging and include a variety of stakeholders: investors, creditors, customers and employees. What do such stakeholders want to know?
There are 3 main categories of ratio:
To fully analyze a set of accounts, you will need a reasonable knowledge of each or these types of ratio, so try to work gradually through the explanations and worksheets to build up your understanding.
The absolute level of profit may provide an indication of the size of the business, but on it's own it says very little about company performance. In order to evaluate the level of profit, profit must be compared and related to other aspects of the business. Profit must be compared with the amount of capital invested in the business, and to sales revenue.
Profitability ratios will inevitably reflect the business environment of the time. So, the business, political and economic climate must also be considered when looking at the trend of profitability for one company over time. Comparisons with other businesses in the same industry segment will provide an indication of management's relative ability to perform in the same business and economic environment.
The key profitability ratios are:
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Return on total assets is a measure of profit in relation to the total assets invested in the business, and ignores the way in which such assets have been financed. The total assets of the business provide one way of measuring the size of the business. This ratio measures the ability of general management to utilize the total assets of the business in order to generate profits.
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You will note that ROTA uses profit before interest and taxes. This is because ROTA is typically used to measure general management performance, and interest and taxes are controlled externally.
ROCE, sometimes called Return on Net Assets, is probably the most popular ratio for measuring general management performance in relation to the capital invested in the business. ROCE defines capital invested in the business as total assets less current liabilities, unlike ROTA, which measures profitability in relation to total assets.
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Capital Employed may be defined in a variety of ways, the most common being Fixed Assets plus working capital, i.e. Current Assets less Current Liabilities. This definition reflects the investment required to enable a business to function.
In order for a business to maximize profitability, management should consider the two elements of ROCE. First, the business needs to sell goods and services at a price that exceeds the cost, which is measured by the net profit margin. Secondly, the business must utilize the capital employed in the business to generate sufficient sales volume and revenue to maximize profitability, which is measured by the net asset turnover. The relationship between the two elements of ROCE are expressed as follows:
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The net profit margin, sometimes known as the trading profit margin measures trading profit relative to sales revenue. Thus a trading profit margin of 10% means that every 1.00 of sales revenue generates .10 (10p) in profit before interest and taxes. Some industries tend to have relatively low margins, which are compensated for by high volumes. Conversely, high margin industries may be low volume. Higher than average net profit margins for the industry may be an indicator or good management.
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The net asset turnover ratio measures the ability of management to utilize the net assets of the business to generate sales revenue. A well-managed business will be making the assets work hard for the business by minimizing idle time for machines and equipment. Too high a ratio may suggest over-trading, that is too much sales revenue with too little investment. Too low a ratio may suggest under-trading and the inefficient management of resources.
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Short-term liquidity is the ability of the company to meet its short-term financial commitments. Short-term liquidity ratios measure the relationship between current liabilities and current assets. Short-term financial commitments are current liabilities, which are typically trade creditors, bank overdrafts PAYE, VAT and any other amounts that must be paid within the next twelve months. Current assets are stocks and work-in-progress, debtors and cash that would normally be re-circulated to pay current liabilities.
The key short-term liquidity ratios are:
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The current ratio is a general indicator of the business's ability to meet its short-term financial commitments. This ratio assumes that all current assets, if required, can be converted to cash immediately in order to meet all current liabilities immediately. Many texts recommend that the current ratio should be at least 2:1, that is current assets should be at least twice the value of current liabilities. Presumably, this is to allow a safety margin, as current assets do not usually achieve their full value if they have to be converted to cash in a hurry.
Nowadays, it is very difficult to prescribe a desirable current ratio. Technological advances in stock and inventory management have reduced the value of stocks on many balance sheets. Aggressive financial management strategies by large companies have resulted in higher levels of trade creditors, and a tightening grip on trade debtors. It is therefore important to look at the trend for an individual business, and to compare businesses within the same industry segment.
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The acid test or quick ratio is the current ratio modified to provide a more prudent measure of short-term liquidity. The acid test ratio deducts stock and work-in-progress from current assets. This approach is more cautious as it recognizes that stock is not always readily converted into cash at full value.
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Long term liquidity or gearing is concerned with the financial structure of the company. Long term liquidity ratios measure the extent to which the capital employed in the business has been financed either by shareholders through share capital and retained earnings, or through borrowing and long term finance.
The key long-term liquidity ratios are:
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The gearing ratio measures the percentage of capital employed that is financed by debt and long term finance. The higher the gearing, the higher the dependence on borrowings and long term financing. The lower the gearing ratio, the higher the dependence on equity financing. Traditionally, the higher the level of gearing, the higher the level of financial risk due to the increased volatility of profits.
Financial managers face a difficult dilemma. Most businesses require long term debt in order to finance growth, as equity financing is rarely sufficient. On the other hand, the introduction of debt and gearing increases financial risk. But the company dependant on equity financing alone is unable to sustain growth. How much debt can a company take on before the benefits of growth are overtaken by the disadvantages of financial risk?
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While the gearing ratio measures the relative level of debt and long term finance, the interest cover ratio measures the cost of long term debt relative to earnings. In this way the interest cover ratio attempts to measure whether or not the company can afford the level of gearing it has committed to.
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When analyzing the financial results of a company, or comparing several companies it is tempting to become so involved in calculating a wide variety of financial ratios that the original purpose is forgotten. Why are we looking at the financial reports? What do we want to know?
Let us go back to the key questions:
These key questions indicate that the financial health of a company is dependent on a combination of profitability, short-term liquidity and long term liquidity. Historically, greater emphasis was placed on profitability. Since the difficulties of the recession in the late 1980s liquidity, both short term and long term, has increased in importance.
Companies, which are profitable, but have poor short term or long term liquidity measures, do not survive the troughs of the trade cycle. As trading becomes difficult in a recession such companies experience financial difficulties and fail, or may be taken over. In contrast, companies, which are not profitable but are cash rich, do not survive in the long term either. Such companies are taken over for their cash flow or by others who believe that they can improve the profitability of the business. Thus, those companies that do succeed and survive over the long term have a well-rounded financial profile, and perform well in all aspects of financial analysis.
It is important when reviewing each aspect of financial performance to highlight any significant changes in performance, either compared to last year or compared to a competitor. Highlighting significant changes enables you to focus on key events or major factors that may have important implications for the company.
Finally, look at financial performance within the context of the political, business and economic environment in which the business operates.