Chapter 9: Financial Ratio Analysis

9.1. Meaning of Financial Ratios

Financial ratio analysis refers to the methods used to evaluate the financial performance of a company by analyzing their liquidity, profitability, efficiency, and leverage using the company’s financial statements such as the statement of profit and loss and the balance sheet. It compares line-item data from the balance sheet or the income statement with an intention of revealing insights about the company’s liquidity, leverage, efficiency and profitability. Financial ratios can be used to compare a company’s performance with the performance of other companies in the industry, or to compare current with past performance.

9.2. Uses of Financial Ratios

Managers, analysts, and investors use information and insights from financial ratio analysis to make informed decisions. Financial ratios show a clear picture of a firm’s financial health so that the investor can decide whether to invest in the company or not. Financial managers also use financial ratios to scrutinize the past and current performance of their companies and make informed strategic decisions. Furthermore, financial ratios are used to make comparison between the performances of several companies and determine the performance of one company in comparison to its peers in the industry. In summary, financial ratio analysis is used in the following ways:

Financial ratios are useful tools for analyzing a company’s financial performance and health. They provide a quick and simple way to evaluate a company’s financial position, profitability, efficiency, liquidity, and solvency. Here are some of the most common uses of financial ratios:

Enables a company to track its performance: Financial ratio helps a company in tracking its value over time. It helps in determining the trends developing in a company. Its importance can be understood by taking an example of a financial ratio – debt to asset ratio. A high debt-to-asset ratio may show a company that is overburdened by debt and may face default risk in the future.
Comparison with other Companies: Financial ratios allow a company to make a comparative judgment regarding its performance – Financial ratios help a company determine its performance in terms of the industry average
Assessing profitability: Financial ratios such as return on investment (ROI), return on equity (ROE), and net profit margin are used to determine a company’s profitability. These ratios help investors and analysts to compare the profitability of different companies in the same industry or sector.
Evaluating efficiency: Financial ratios such as asset turnover, inventory turnover, and accounts receivable turnover are used to assess a company’s efficiency in managing its assets, inventory, and receivables. These ratios help to identify areas where a company can improve its efficiency and reduce costs.
Measuring liquidity: Financial ratios such as current ratio and quick ratio are used to determine a company’s ability to meet its short-term obligations. These ratios help investors and analysts to evaluate a company’s liquidity and its ability to handle unexpected expenses or downturns in the market.
Assessing solvency: Financial ratios such as debt-to-equity ratio and interest coverage ratio are used to assess a company’s long-term financial health and ability to meet its debt obligations. These ratios help investors and analysts to evaluate a company’s solvency and its ability to withstand financial stress.
Comparing performance: Financial ratios are useful for comparing a company’s financial performance over time or against its competitors. By comparing ratios such as ROE, net profit margin, or debt-to-equity ratio, investors and analysts can identify trends and make informed investment decisions.

Overall, financial ratios are important tools for assessing a company’s financial health and performance, identifying areas for improvement, and making informed investment decisions.

9.3. How Financial Ratios Assist in Measuring the Financial Performance of a Business

Ratios can be very useful in measuring the financial performance of a business. They provide insight into the company’s financial health by comparing different financial numbers to each other. Some of the ways ratios can assist in measuring financial performance include:

Liquidity Ratios: These ratios help to determine the company’s ability to meet short-term obligations. Examples include the current ratio and the quick ratio. The current ratio is calculated by dividing current assets by current liabilities. The quick ratio, also known as the acid-test ratio, is calculated by subtracting inventory from current assets and dividing the result by current liabilities. A higher current ratio or quick ratio indicates better liquidity.
Profitability Ratios: These ratios help in measuring the company’s financial performance by determining how profitable the company is. Examples include the gross profit margin, net profit margin, and return on equity. The gross profit margin is calculated by dividing gross profit by revenue. The operating profit margin is calculated by dividing operating profit by revenue. The net profit margin is calculated by dividing net profit by revenue. A higher profit margin indicates better profitability.
Efficiency Ratios: These ratios help to determine how efficiently the company is using its resources. Examples include inventory turnover and accounts receivable turnover. The asset turnover ratio is calculated by dividing revenue by total assets. The inventory turnover ratio is calculated by dividing cost of goods sold by average inventory. The accounts receivable turnover ratio is calculated by dividing revenue by average accounts receivable. A higher efficiency ratio indicates better management of assets and liabilities.
Solvency Ratios: These ratios are used to measure a company’s financial performance by establishing the company’s ability to meet long-term obligations. Examples include the debt-to-equity ratio and the interest coverage ratio.

By analyzing these ratios over time, investors, lenders, and other stakeholders can get a better sense of the company’s financial performance and make more informed decisions about whether to invest in, lend to, or do business with the company. By using these ratios, analysts and investors can gain insight into a company’s financial health, compare it to competitors or industry standards, and identify areas for improvement. It’s important to note, however, that ratios should not be used in isolation and should always be considered in the context of other factors affecting a company’s financial performance.

9.4. Appraising a Company’s Financial Performance

Financial performance refers to the complete evaluation of the overall financial standing of a company in various categories such as liabilities, equity, expenses, revenue, profitability and assets. A company’s financial performance is appraised using various mathematical formulas that enable stakeholders to understand the true financial position of the company.

Financial analysis can be carried out by evaluating a firm’s financial statements to help internal and external users to understand the company’s financial performance. The process of appraising a company’s financial performance involves the analysis of four financial statements of the company: income statement, balance sheet, cash flow statement, and annual report.

1) Balance Sheet

The balance sheet is a balance sheet is a financial statement that reports a company’s assets, liabilities, and equity at a specific point in time. It provides a snapshot of a company’s financial position and is an essential component of financial reporting. In financial statement analysis, an organization’s balance sheet is looked at to determine the operational efficiency of a business.

The balance sheet provides information for asset analysis, which focuses on cash and cash equivalents, inventory, property and equipment, and motor vehicles. Understanding the company’s position in terms of assets is necessary to predict the future growth of the company.

Another type of financial analysis that utilizes the components of a balance sheet is examining long term and short term liabilities to establish the liquidity of the firm and its ability of the firm to pay off its debts. A balance sheet also has an equity section which provides insight about the firm’s share capital.

2) Income Statement

An income statement is a financial statement that shows a company’s revenues and expenses over a period of time, typically a month, a quarter, or a year. It’s also known as a profit and loss statement or P&L statement. The purpose of an income statement is to show how much money a company earned or lost during the period.

The income statement starts with revenues at the top, which includes all the money a company earned from its operations, such as sales revenue, service revenue, and interest income. Then, the expenses are listed below the revenues. The expenses include all the costs associated with running the business, such as cost of goods sold, salaries and wages, rent, utilities, and marketing expenses. The difference between the revenues and expenses is called net income or net loss, depending on whether the company made a profit or a loss during the period.

An income statement is important for investors, creditors, and analysts because it provides a clear picture of a company’s financial performance over a period of time. It can be used to evaluate a company’s profitability, efficiency, and overall financial health. By comparing income statements from different periods or to those of other companies in the same industry, investors and analysts can identify trends and make informed decisions about whether to invest in or lend money to a company.

3) Cash Flow Statement

A cash flow statement is a financial statement that shows the inflows and outflows of cash and cash equivalents during a specific period of time. It provides information about how cash is generated and used by a company, which is important for understanding its financial health and ability to meet its financial obligations.

The cash flow statement is divided into three sections: operating activities, investing activities, and financing activities.

Items in operating activities section of a cash flow statement may include:

Net income
Adjustments to reconcile net income to cash generated by operating activities:
- Depreciation and amortization
- Deferred income tax expense
- Others
Accounts receivable
Inventories
Other current and non-current assets
Accounts payable
Deferred revenue
Other current and non-current liabilities

Items in the investing activities section include:

Purchases of marketable securities
Proceeds from maturities of marketable securities
Proceeds from sales of marketable securities
Cash spent in business acquisitions
Cash use for acquisition of property, plant and equipment (PPE)
Payments for the acquisition of intangible assets

Items in financing activities section include:

Payment of dividends and rights
Repurchase of common stock
Proceeds from issuance of long term debt
Others

This list is not exhaustive. You have to figure out which components in a particular company can generate or spend cash in the form of operating, investing, and financing activities.

The net increase or decrease in cash and cash equivalents for the period is shown at the bottom of the statement. A positive number indicates that the company generated more cash than it used during the period, while a negative number indicates that the company used more cash than it generated.

The cash flow statement is important for investors, creditors, and analysts because it provides information about a company’s ability to generate cash, pay its debts, and invest in its business. By analyzing the cash flow statement, investors and analysts can assess the quality of a company’s earnings and make informed decisions about whether to invest in or lend money to a company.

4) Annual Report

The last statement, the annual report, provides qualitative information which is useful to further analyze a company’s overall operational and financing activities. The annual report consists of all the statements listed above but adds additional insights and narratives on critical figures within the organization.

The additional insights and narratives within the annual report include an extensive narrative breakdown of the various business segments, benchmarks, and overall growth.

Measuring Financial Performance

The financial performance analysis of a company involves the use of formulas and ratios that are applied to various components of the firm’s financial statements to establish its financial position and performance. There are primarily five types of financial ratios that can be used to measure the financial performance of a company.

Types of Financial Ratios

There are several financial ratios which can be used to analyze the financial performance of a company. These ratios are categorized into five major types: liquidity ratios, leverage ratios, efficiency ratios, profitability ratios, and market value ratios.

1) Liquidity Ratios

These are financial ratios that are used to measure the company’s ability to pay off its financial obligations. Liquidity ratios include:

Current Ratio

Current ratios are used to measure the company’s ability to pay its short term liabilities using current assets. This ratio can be calculated using the following formula:

Current ratio = Current assets/Current liabilities

The current ratio uses information from the balance sheet. A higher current ratio indicates that a company has more current assets than current liabilities, which means that the company can easily pay off its short term liabilities using existing current assets. Current assets are those assets that can be converted into cash within one year, such as cash or inventory. A current of at least 2 is preferable since the company can pay off its current liabilities two times over. A current ratio of 2 means that the company’s current assets are double the current liabilities. A current ratio of less than 1 means that the company’s current assets are less than current liabilities; hence it cannot be able to fully pay off its current liabilities using current assets.

Acid-test Ratio

The acid-test ratio refers to a financial ratio that measures the ability of a firm to pay off its short-term liabilities using quick assets, or assets that can be easily turned into cash. The formula for calculating an acid-test ratio is:

Acid-test ratio = (Current assets – Inventories)/Current liabilities

Inventories are subtracted in the formula because they are not easily converted into cash. The acid-test ratio of greater than 1.5 is preferable because the company has more liquid assets to pay off financial obligations as they fall due. The higher the acid-test ratio, the higher the liquidity of the firm.

Cash Ratio

Cash ratio refers to the measure of the company’s ability to pay off its short term liabilities using cash and cash equivalents. This financial ratio can be calculated using the following formula:

Cash ratio = Cash and Cash equivalents/Current Liabilities

A high cash ratio indicates that the company can be able to pay off its current liabilities using cash in hand and cash in bank.

2) Leverage Ratios

This type of financial ratio is used to calculate a company’s leverage, or debt level compared to equity. Leverage ratios are also called solvency ratios; they compare a firm’s debt levels with its equity, earnings, and assets. There are several types of leverage ratios including:

Debt Ratio

The debt ratio refers to the measure of a company’s assets that are funded by debt. It is calculated using the following formula:

Debt ratio = Total liabilities/Total assets

If the debt ratio is greater than 1, it means that the company has more liabilities than assets, which shows a high leverage or high debt level. In this case, decision makers will avoid borrowing additional funds because the company is already in huge debts.

Debt-to-Equity Ratio

It is a financial ratio that evaluates a company’s financial leverage by dividing its liabilities by shareholder equity. It tells you the borrowing patterns of your company and if your company is borrowing too much. If the value is between zero and one, we can say that the company has safe margins. The formula for calculating debt-to-equity ratio is:

Debt to equity ratio = Total liabilities / Shareholder’s equity

Interest Coverage Ratio

The interest coverage ratio shows how easily a company can pay its interest expenses. It is calculated using the following formula:

Interest coverage ratio = Operating income / Interest expenses

3) Efficiency Ratios

Efficiency ratios are ratios that are used to measure how well a company is using its assets to increase their earnings.

Asset turnover ratio

The asset turnover ratio measures the ability of a firm to generate sales using its assets. It determines the company’s efficiency by comparing assets to sales as shown in the formula below:

Asset turnover ratio = Net sales/Average total assets

The asset turnover ratio indicates how well a company is utilizing its resources to generate revenue. A higher ratio shows that the company is able to utilize its assets more efficiently to generate revenue.

Inventory Turnover Ratio

The inventory turnover ratio is the measure of the number of times that a company is able to sell its inventory within a specific time. It is calculated using the following formula:

Inventory turnover ratio = Cost of goods sold/Average inventory

A higher the ratio indicates that the company is able to sell its inventory faster, or is able to manage its inventory well in relation to the cost of sales. A low inventory turnover ratio might be a sign of weak sales or excessive inventory, also known as overstocking.

Accounts Receivable Turnover Ratio

The accounts receivable turnover ratio measures how many times a company can turn receivables into cash over a given period:

Receivables turnover ratio = Net credit sales/Average accounts receivable

A high value indicates that the company is able to turn its receivables into cash faster, or is able to collect its debts faster

Days sales inventory ratio

This ratio calculates the number of days that a company can hold on before selling its inventory to customers. The formula for calculating the days sales inventory ratio is shown below:

Days sales in inventory ratio = 365 days / Inventory turnover ratio

A larger number indicates that the company takes longer to convert stock into sales.

4) Profitability Ratio

These are the ratios that are used to calculate the firm’s ability to generate income compared to its revenue, assets, operating costs, and equity. Some of the profitability ratios include:

Gross Margin Ratio

A gross margin ratio is a type of profitability ratio that measures profit margins of a company by comparing gross profits with net sales. It shows the amount of profits that a firm generates after paying off its cost of sales. The formula for calculating gross profit ratio is shown below:

Gross margin ratio = Gross profit/Net sales

A higher gross profit margin indicates that the company is able to generate more sales at lower costs to make profits. The aim of every firm is to increase sales while minimizing the cost of goods sold.

Operating Margin Ratio

The operating margin ratio measures profitability of a firm by comparing the operating income of the company to net sales. This ratio determines the ability of a firm to generate revenue from its operations for every shilling of sales made. It is calculated using the following formula:

Operating margin ratio = Operating income/Net sales

A large operating margin ratio shows that the company returns more of its sales as profits, meaning that operations are run more efficiently to make profits.

Return on Assets Ratio (RAO)

The return on assets ratio measures how efficiently a company is using its assets to generate profit. This ratio is calculated using the following formula:

Return on assets ratio = Net income/Total assets

The ROA figure gives investors an idea of how effective the company is in converting the money it invests into net income. A higher return on assets indicates that the company is able to generate more income with fewer assets; this indicates proper or efficient utilization of assets to generate income.

Return on Equity Ratio

The return on equity (ROE) is a ratio that measures the ability of the firm to earn profits from its equity capital. This ratio can be calculated using the following formula:

Return on equity ratio = Net income/Shareholder’s equity

Return on equity is often used by investors to see whether their share contributions are properly utilized to generate profits. A higher return on investment indicates that the company is efficient in converting equity capital into profits.

5) Market Value Ratios

Market value ratios are used to evaluate the share price of a company’s stock. It is a type of financial ratio that measures how effective a firm is in creating value for shareholders through share prices. If the share price rises, it means higher value for the investor. Common market value ratios include the following:

Book Value per Share Ratio

The book value per share ratio is a type of market value ratio that is used to measure the value of each share of a company in the market. This ratio is calculated by dividing the total amount of shareholders’ equity by the number of outstanding shares.

Book value per share ratio = (Shareholder’s equity – Preferred equity) / Total common shares outstanding

This ratio provides a benchmark to check if the market value of each share is high or low, which can then be analyzed to make buying and selling decisions. A high book value per share ratio indicates that the true share value is high, giving investors the confidence to hold their investments or buy more shares.

Dividend Yield Ratio

The dividend yield ratio is the measure of the dividend amount that is attributed to shareholders, relative to the market value per share. This ratio can be calculated using the following formula:

Dividend yield ratio = Dividend per share/Share price

In financial ratio analysis, this ratio tells us the percentage of a company’s share price that it pays out in dividends each year. For example, if a company’s share price is $10 and it pays dividends of $0.5, the dividend yield will be 0.5/10 = 5%. A high dividend yield ratio indicates that the company’s shares yield more dividends for shareholders.

Earnings per Share Ratio

The earnings per share ratio refers to a type for market value ratio which measures the amount of net income that is earned for every outstanding share. This ratio is calculated by dividing the net earnings by the total number of shares outstanding.

Earnings per share ratio = Net earnings / Total shares outstanding

Earnings per Share indicates the company’s profitability by showing how much money a business makes for each share of its stock. A higher EPS indicates that the company is profitable.

Price-to-Earnings Ratio

The price-to-earnings ratio is a type of market value ratio that compares the share price with the earnings per share.

Price-earnings ratio = Share price / Earnings per share

By and large, the price-to-earnings ratio indicates the amount of money that an investor can expect to invest in a company in order to receive $1 of that company’s earnings. A higher P/E ratio indicates that the investor has to put more money into shares to get more earnings.

9.5. Circumstances in which ratio analysis is most effective and those where it is of limited value

Ratio analysis is a useful tool for evaluating the financial performance and health of a company. However, its effectiveness can be limited by several factors. Here are some circumstances where ratio analysis is most effective and those where it is of limited value:

Most effective circumstances for ratio analysis:

Comparative analysis: Ratio analysis is most effective when used for comparative analysis. It can be used to compare the financial performance of a company with its competitors or industry standards. This helps in identifying areas where a company is performing well and areas that need improvement.
Long-term trend analysis: Ratio analysis is useful for long-term trend analysis. By analyzing the ratios over a period, it is possible to identify trends and changes in a company’s financial performance.
Industry-specific analysis: Ratio analysis is most effective when used to analyze companies within a specific industry. It can help in identifying industry-specific trends and benchmarks.
Internal analysis: Ratio analysis is useful for internal analysis, where a company can compare its current financial performance with its past performance. This helps in identifying areas of improvement and making informed decisions.

Circumstances where ratio analysis is of limited value:

Lack of comparability: Ratio analysis is of limited value when there is a lack of comparability between companies or industries. This can happen due to differences in accounting practices or industry-specific factors.
One-dimensional analysis: Ratio analysis is one-dimensional and cannot provide a complete picture of a company’s financial performance. It should be used in conjunction with other financial analysis tools.
Incomplete data: Ratio analysis is of limited value when the financial statements of a company do not provide complete and accurate information. This can happen due to accounting errors or fraud.
Changing economic conditions: Ratio analysis is of limited value in changing economic conditions. Economic conditions can have a significant impact on a company’s financial performance, and the ratios may not accurately reflect the company’s financial health.

9.6. Why ratios and performance data will vary from one type of business to another

Ratios and performance data will vary from one type of business to another due to several reasons, including:

Business model: The business model of a company determines its revenue streams, cost structure, and profitability ratios. For example, a manufacturing company will have different ratios and performance data compared to a service-based company.
Industry-specific factors: Different industries have unique characteristics, and hence, ratios and performance data will vary across industries. For instance, the profitability ratios of a high-tech industry will differ from those of a construction industry.
Size of the company: The size of a company can also impact its ratios and performance data. Small companies may have lower revenue and profitability ratios compared to large companies, but they may have higher efficiency ratios.
Geographical location: The location of a company can also impact its ratios and performance data. Companies operating in different regions or countries may have different tax laws, labor laws, and market conditions, leading to variations in their ratios and performance data.
Accounting methods: Different companies may use different accounting methods, such as cash basis or accrual basis accounting. This can impact their ratios and performance data, as certain ratios may be more relevant under one accounting method than another.

Therefore, it is essential to consider these factors when analyzing ratios and performance data of different businesses. Comparing the ratios and performance data of two companies from different industries or with different business models may not provide an accurate picture of their financial health.

9.7. Interpretation of cash flow statements

A cash flow statement can be calculated and prepared in two primary ways: method and indirect method.

Direct Method

The direct method of calculating a cash flow statement involves the use of all transactional information that affect cash during a specific period. To prepare a cash flow statement using the direct method, you are required to add all cash collected from operating activities and subtract all the cash dispensed from operating activities.

Indirect Method

Another method of preparing a cash flow statement is the indirect method, which uses the accrual accounting method to record accounting transactions such as revenues and expenses – as opposed to when cash was paid or received. These accrual entries and adjustments will cause a discrepancy between the cash flow from operating activities and net income. Instead of organizing transactional data like the direct method, the accountant starts with the net income number found from the income statement and makes adjustments to undo the impact of the accruals that were made during the period.

How to Interpret a Cash Flow Statement

All financial statements are analyzed to give an insight into the financial health of an organization. For instance, a cash flow statement can be used to establish whether a company is growing, mature, or profitable. A company that has fluctuating cash flows indicates that the firm is too risky to invest in. On the other hand, a positive cash flow indicates good potential for growth in the long term. Generally cash flow statements are used in making internal decisions of the company such as hiring or firing employing, budgeting, and acquisition of assets. The company makes decision based on whether it has positive or negative cash flows.

Positive Cash Flow

When the cash flow statement indicates a positive cash flow, it means that the company is receiving more cash than it is spending. More cash are coming while less money is going out. A positive cash flow is ideal for any company because it ensures that the company has enough cash to pay its liabilities, run operations, invest in projects, and pay dividends.

Negative Cash Flow

A negative cash flow occurs when a company’s cash outflows exceed its cash inflows. A negative cash flow may reflect higher expenditures than income. It may also be caused by a company’s decision to invest in a particular project such as purchasing an asset for future growth. Having a negative cash flow does not necessarily mean a bad situation because the company may forego immediate cash flow to invest in a project that will generate more income in the future.

Example of a Cash Flow Statement

The figure below shows an example of a cash flow statement from a fictional company indicating cash from operating, investing, and financing activities.

From the figure above, the fictional company started with cash of $10.75 billion. The company’s cash flows are then broken down into cash from operating activities, investing activities, and financing activities. The operating activities brought net cash flows of $53.66 while cash spent in investing activities amounted to $33.77 billion. Lastly, the company recorded cash outflows from financing activities of $16.3 billion. As a result, the company ended up with a positive cash flow of $3.5 billion, which shows an increase in cash and cash equivalents within the review period. This can be added to the opening cash to arrive at the total end year cash of $14.26 billion. The positive cash flow indicates that the company has enough cash to pay its financial obligations and invest for future growth. A significant amount of cash in the company was generated from operating activities, showing that the company’s operations are efficient.

9.7. Non-Financial Analysis

Non-financial analysis refers to the evaluation of a company’s performance based on factors other than its financial statements. This type of analysis focuses on qualitative and quantitative factors that may affect a company’s ability to generate revenue, manage risk, and create value. Non-financial analysis may include factors such as:

Management quality: The skills and experience of a company’s management team, their decision-making process, and their ability to execute strategies.
Brand reputation: A company’s brand value and reputation in the market can impact its ability to attract customers and generate revenue.
Customer satisfaction: The level of customer satisfaction and loyalty can indicate a company’s ability to retain customers and generate repeat business.
Corporate social responsibility: A company’s efforts towards sustainable and ethical practices can affect its brand value and reputation in the market.
Employee satisfaction: The level of employee satisfaction and engagement can impact a company’s productivity, efficiency, and ability to attract and retain talent.
Regulatory environment: The legal and regulatory environment in which a company operates can impact its ability to conduct business and generate revenue.

Non-financial analysis is often used in combination with financial analysis to provide a comprehensive evaluation of a company’s performance. It can provide insights into the factors that may affect a company’s long-term sustainability and value creation potential.

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