Ratios

Introduction

Although the profit and loss account and balance sheet are the main sources of financial information on a company which are readily available, skill is required to make sense of them. Ratio analysis is a technique used to describe and interpret the relationships of certain financial data in the financial statements which would otherwise be devoid of meaning.

Ratios can be used to assess a company's past financial performance, evaluate its financial stability and to predict its future financial performance.

Financial ratios can be organised into six main categories:

Liquidity Measurement Ratios

Liquidity ratios attempt to measure a company's ability to pay off its short-term debt obligations. This is done by comparing a company's most liquid assets (or, those that can be easily converted to cash), its short-term liabilities.

Some important liquidity ratios are:

a) Current Ratio

b) Quick Ratio

c) Cash Ratio

d) Cash Conversion Cycle

Profitability Indicator Ratios

These ratios, much like the operational performance ratios, give users a good understanding of how well the company utilized its resources in generating profit and shareholder value.

Some profitability ratios are listed below:

a) Return On Assets

b) Return On Equity

c) Return On Capital Employed

Debt Ratios

These ratios give users a general idea of the company's overall debt load as well as its mix of equity and debt. Debt ratios can be used to determine the overall level of financial risk a company and its shareholders face. In general, the greater the amount of debt held by a company the greater the financial risk of bankruptcy.

Types:

a) Debt Ratio

b) Debt-Equity Ratio

c) Capitalization Ratio

d) Interest Coverage Ratio

e) Cash Flow To Debt Ratio

Operating Performance Ratios

These ratios look at how well a company turns its assets into revenue as well as how efficiently a company converts its sales into cash. Basically, these ratios look at how efficiently and effectively a company is using its resources to generate sales and increase shareholder value. In general, the better these ratios are, the better it is for shareholders.

Some operating performance ratios:

a) Fixed-Asset Turnover

b) Sales/Revenue Per Employee

c) Operating Cycle

Cash Flow Indicator Ratios

Cash flow indicators focus on the cash being generated in terms of how much is being generated and the safety net that it provides to the company. These ratios can give users another look at the financial health and performance of a company.

Some types:

a) Operating Cash Flow/Sales Ratio

b) Free Cash Flow/Operating Cash Ratio

c) Cash Flow Coverage Ratio

d) Dividend Payout Ratio

Investment Valuation Ratios

These ratios can be used by investors to estimate the attractiveness of a potential or existing investment and get an idea of its valuation.

Some investment valuation ratios:

a) Price/Book Value Ratio

b) Price/Cash Flow Ratio

c) Price/Earnings Ratio

d Price/Earnings To Growth Ratio

e) Price/Sales Ratio

f) Dividend Yield

Care must be taken, however, because there is no agreed definitions of the ratios and different sources may use different calculations.

Limitations of Ratio Analysis

• They only use quantitative data. They may need to consider qualitative factors, such as the skills of the management, the rate of change in the market, and the industrial record.

• Need to consider the type of firm. This is because very firm is in different stages of development. Also one must consider the objectives of the owners, eg. a low profitability ratio may be acceptable in the early stages of growth when the owners are investing heavily in equipment and training, but if it is in the mature stage owners will be less happy.

• The figures in a balance sheet only relate to that day. They may change radically every day, the one on the chosen day may be not be typical and consequently any ratios calculated using these figures are not necessarily representative.

• There is considerable subjectivity involved, as there is no “correct” number for the various ratios. Further, it is hard to reach a definite conclusion when some of the ratios are favourable and some are unfavourable.

• Ratios may not be strictly comparable for different firms due to a variety of factors such as different accounting practices or different fiscal year periods. Furthermore, if a firm is engaged in diverse product lines, it may be difficult to identify the industry category to which the firm belongs.

• Ratios are based on financial statements that reflect the past and not the future. Unless the ratios are stable, it may be difficult to make reasonable projections about future trends. Furthermore, financial statements such as the balance sheet indicate the picture at “one point” in time, and thus may not be representative of longer periods.

• Financial