Financial ratio analysis
/What is Ratio Analysis?
Financial ratios compare the results in different line items of the financial statements. The analysis of these ratios is designed to draw conclusions regarding the financial performance, liquidity, leverage, and asset usage of a business. This information is then used to decide whether to invest in or extend credit to a business. Ratio analysis is widely used, since it is solely based on the information located in the financial statements, which is generally easy to obtain. In addition, the results can be compared to industry averages or to the results of benchmark companies, to see how a business is performing in comparison to other organizations.
Related AccountingTools Courses
The Interpretation of Financial Statements
Types of Financial Ratios
The categories of financial ratios that are used for analysis purposes are noted below, under the categories of performance ratios, liquidity ratios, leverage and coverage ratios, and activity ratios.
Performance Ratios
Performance ratios are derived from the revenue and aggregate expenses line items on the income statement, and measure the ability of a business to generate a profit. The most important of these ratios are the gross profit ratio and net profit ratio. A business is expected to be able to generate a positive net profit ratio that is comparable to the results reported by its peers. If not, then investors will be less likely to put funds into the business.
Liquidity Ratios
Liquidity ratios compare the line items in the balance sheet, and measure the ability of a business to pay its bills in a timely manner. Chief among these ratios are the current ratio and quick ratio, which compare certain current assets to current liabilities. The current ratio compares current assets to current liabilities, under the assumption that having more current assets than current liabilities allows a business to liquidate the assets to pay off the liabilities. The quick ratio is the same as the current ratio, except that it does not include inventory, on the grounds that it can take a long time to liquidate inventory.
Leverage and Coverage Ratios
Leverage and coverage ratios are used to estimate the comparative amounts of debt, equity, and assets of a business, as well as its ability to pay off its debts. The most common of these ratios are the debt to equity ratio and the times interest earned ratio. The times interest earned ratio calculates the number of times that earnings can pay off the current interest expense; as long as enough profits are being generated to do so, then a borrower is judged to be a reasonable credit risk. However, this analysis does not address whether a borrower can also pay back the principal on a loan.
Activity Ratios
Activity ratios are used to calculate the speed with which assets and liabilities turnover, by comparing certain balance sheet and income statement line items. Rapid asset turnover implies a high level of operational excellence. The most common of these ratios are as follows:
Days sales outstanding. Days sales outstanding (DSO) is the average number of days that receivables remain outstanding before they are collected. It is used to determine the effectiveness of a company's credit and collection efforts in allowing credit to customers, as well as its ability to collect from them. The formula is as follows:
(Accounts receivable ÷ Annual revenue) × Number of days in the year = Days sales outstanding
Inventory turnover. Inventory turnover is the average number of times in a year that a business sells and replaces its inventory. Low turnover equates to a large investment in inventory, while high turnover equates to a low investment in inventory. The formula is as follows:
Annual cost of goods sold ÷ Ending inventory = Inventory turnover
Payables turnover. Accounts payable turnover is a ratio that measures the speed with which a company pays its suppliers. If the turnover ratio declines from one period to the next, this indicates that the company is paying its suppliers more slowly, and may be an indicator of worsening financial condition. The formula is as follows:
Total supplier purchases ÷ ((Beginning accounts payable + Ending accounts payable) ÷ 2) = Payables turnover
These measurements can be taken too far. For example, achieving a very high inventory turnover level could mean that a business is maintaining no finished goods on hand at all, and is instead forcing its customers to pay in advance for goods that may not be available for several weeks or months. In this case, the business is indeed reporting a high inventory turnover level, but is also providing very poor customer service.
The Need for Consistent Financial Reporting
Financial ratio analysis is only possible when a company constructs its financial statements in a consistent manner, so that the underlying general ledger accounts are always aggregated into the same line items in the financial statements. Otherwise, the provided information will vary from one period to the next, rendering long-term trend analysis useless.
Example of Financial Ratio Analysis
A credit analyst reviews the financial statements of a customer to see if it qualifies for trade credit, rather than paying in cash for goods delivered to it. The firm’s balance sheet contains current assets of $200,000 and current liabilities of $400,000, as well as a debt level that is three times higher than its equity, and a reported net profit ratio of 1%. Based on the applicant’s minimal profitability, excessive degree of leverage and poor current ratio, the analyst decides not to extend trade credit to the customer.