The financial statements are useful to a wide range of users such as the company’s management, potential and existing investors, lenders, business rating agencies, customers, suppliers, employees, and several others. Each of these users view the financial statements from different perspectives for different reasons.
There are multiple ways of analysing financial statements such as trend analysis, comparing financial statements of similar entities within the same industry, cash flow analysis, ratio analysis and several others. In this article, we would be focusing on Ratio Analysis.
Ratio analysis is a quantitative method of using financial ratios to gain insight into a company’s liquidity, operational efficiency, and profitability by studying its financial statements such as the statement of financial position and the statement of profit or loss and other comprehensive income. (Bloomenthal, 2021).
Financial ratios are divided into the following categories:
- Liquidity Ratios
- Profitability Ratios
- Solvency Ratios
- Market Prospect/Investors’ Ratios
These ratios measure a company’s ability to settle its short-term obligations without raising external capital. Ratios within this category comprise the following:
Current Ratio: This ratio is used to show the entity’s availability of current assets to settle its current liabilities. A high current ratio shows that the entity has enough current assets to settle its current liabilities.
Current Ratio = current assets/current liabilities (Fernando, 2021)
Acid Test Ratio: This ratio is used to show the entity’s availability of current assets to settle its current liabilities. However, it differs from the Current Ratio by disregarding the less liquid elements of current assets such as Inventory.
Acid Test Ratio = ( cash + marketable securities + accounts receivable)/ current liabilities (Hayes, 2021)
These ratios measure how well the company can generate profits from its operations. Ratios within this category comprise the following:
Gross Profit Margin: This ratio shows the entity’s profit after accounting for cost of sales. This can be sourced from the entity’s Statement of Profit or Loss and Other Comprehensive Income.
Gross Profit Margin = Revenue – Cost of Sales (Hayes, 2021)
Net Profit Margin: This ratio shows the entity’s profit after accounting for all costs and taxes. This can be sourced from the entity’s Statement of Profit or Loss and Other Comprehensive Income. (Hayes, 2021)
Return on Assets: An entity is expected to use its assets to generate revenue. This ratio measures how effective the entity is in generating revenue and profits from assets utilization.
Return on Assets = net profit/total assets (Hargrave, 2021)
Return on Equity: Existing and potential shareholders should be interested in measuring how effectively the entity is in generating revenue and profits from its shareholders’ invested capital.
Return on Assets = net profit/average shareholders’ equity (Hayes, 2021)
Where liquidity ratios consider the entity’s ability to use its assets to settle its debts from a short-term view, solvency ratios consider the same but from a long-term view making it useful to potential and existing lenders. Ratios within this category comprise the following:
Gearing Ratio: This ratioshows the extent to which an entity is funded by debt versus equity. A higher gearing ratio shows the entity is being run more by debt than by the shareholders’ equity. A gearing ratio over 50% is generally not a good sign of the entity’s financial stability due to the risks of loan defaults which may lead to bankruptcy whenever the entity has low cashflows. An entity without debt may be viewed as not utilizing the tax benefits of having debts as interest payments on debt are tax-deductible. Hence, each entity is expected to maintain an optimal gearing ratio where the benefits of debt are utilized yet, the entity is considered lowly geared enough to still attract investors.
Gearing Ratio = (long term debt + short term debt + bank overdrafts)/shareholders’ equity (Boyte-White, 2021)
Interest Coverage Ratio: An entity with debt has interest payments to make to lenders. Defaulting on these payments due to limited cashflows may lead to bankruptcy. This ratio measures how well the entity’s current profits can pay its current interest payments.
Interest Coverage Ratio = Profits before interest and tax / interest expense (Hayes, 2021)
MARKET PROSPECT/INVESTORS’ RATIOS
Investors are interested in estimating their possible returns from investing in a particular entity. These ratios assist in achieving this. Ratios within this category comprise the following:
Dividend Yield: This ratio shows how much a company pays out in dividends each year relative to its share price. It shows how much the shareholders are earnings relative to the entity’s current share price in the market.
Dividend Yield = annual dividends per share / price per share (Fernando, 2021)
Earnings per Share: This ratio measures how much a company earns per the number of ordinary shares it has in issue. This shows how effective the entity is in utilizing the shareholders’ investments.
Earnings per Share = net profit-preferred dividend / number of ordinary shares as at year-end (Fernando, 2021)
Price to Earnings Ratio: This ratio measures an entity’s current share price relative to its earnings per share. It is used to determine the reasonability of the entity’s share price. A high P/E ratio shows that the entity’s share price is overvalued as the entity is not earning per share is significantly lower than its market price per share.
Price to Earnings Ratio = market value per share/earnings per share (Fernando, 2021)
Dividend Payout Ratio: This ratio measures the percentage of its profits an entity pays shareholders as dividends rather than reinvesting in the entity to increase growth. When using this ratio, always consider the entity’s age. A new firm would rather reinvest its profits for more growth while an older firm with a strong retained earnings balance will be comfortable paying out higher dividends.
Dividend Payout Ratio =dividend paid/net profit (Hayes, 2021)
LIMITATIONS OF RATIO ANALYSIS
Note that these ratios need to be considered as a whole to properly assess the financial health of an entity as they each have limitations. Ratio Analysis should also be considered in a trend format. An entity with a steadily increasing dividend payout ratio over the years is showing signs of a healthy growth. Also, take close looks at the elements of each formula as some may be influenced by certain situations that make that ratio less relevant for that entity.
Let us consider Return on Equity. The numerator is Net Profit. What if the entity is highly geared and the net profit was generated mostly from the cash flows from debt, would we still conclude that the net profit shows a true view of the entity’s return on equity?
Let us also consider the dividend-related ratios. Is the entity paying out high dividends to attract investors whereas those dividend payouts not reinvested in the entity are negatively affecting the entity’s growth? Is the entity’s dividend yield high because its market prices are declining due to its declining growth, yet the entity is still paying out high dividends, mostly sourced from retained earnings accumulated over the years in a bid to attract investors?
Please drop your questions, comments and other suggestions in the comment box.
Thank you for reading and look out for our next article!
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