Financial Decision Making: Module 10 - Ratio Analysis Study Guide

Module 10: Ratio Analysis - Objectives and Overview

Financial statement analysis is an evaluation of the financial statements designed to identify significant trends or relationships among the items contained within them. This module aims to provide a comprehensive understanding of a business firm’s financial situation by building upon information provided directly in the financial statements.

  • Module Objectives:
    • Explain the use of financial ratios in financial statement analysis.
    • Describe, apply, and analyse the use of different financial statement ratios in ratio analysis.
    • Describe the limitations of financial analysis.
    • Explain the impact of capital markets research on the role of financial statement analysis.

Fundamentals of Financial Ratios

A financial ratio shows the relationship of one number on a financial statement to another number. Ratios are tools designed to assess various aspects of a firm's financial status and allow for meaningful comparisons between firms of different sizes.

  • Calculation Method: A financial statement ratio is calculated by dividing the dollar amount of one item reported in the financial statements by the dollar amount of another item reported.
  • Relational Scope: Relevant relationships can exist between items within the same financial statement or between items reported across two or more different financial statements.
  • Primary Types of Ratios:
    • Profitability ratios.
    • Liquidity ratios.
    • Financial stability ratios.

Profitability Ratios

Profitability analysis consists of tests used to evaluate an entity’s financial performance during the year. Profit potential is essential for long-term creditors, shareholders, suppliers, and trade unions, as an entity must operate at a satisfactory profit to survive and maintain relationships with stakeholders.

Core Calculation Definitions

  • Gross Sales Revenue:Gross Sales Revenue=Total of Sales Receipts\text{Gross Sales Revenue} = \text{Total of Sales Receipts}

  • Net Sales:Net Sales=Gross Sales Revenue−Returns−Discounts Allowed\text{Net Sales} = \text{Gross Sales Revenue} - \text{Returns} - \text{Discounts Allowed}

  • Gross Profit:Gross Profit=Net Sales−Cost of Sales\text{Gross Profit} = \text{Net Sales} - \text{Cost of Sales}

  • Net Profit:Net Profit=Gross Profit−All Other Expenses\text{Net Profit} = \text{Gross Profit} - \text{All Other Expenses}

Key Profitability Measures
  • Net Profit Margin Ratio:
    • Also referred to as "Return on Sales."
    • Reflects the net income dollars generated by each dollar of sales.
  • Gross Profit Margin Ratio:
    • Reflects gross income dollars generated by each dollar of sales.
    • Calculation logic: Net Sales−Cost of Sales\text{Net Sales} - \text{Cost of Sales}.
  • Total Asset Turnover Ratio:
    • Measures the activity of the assets.
    • Assesses the ability of the firm to generate sales through the use of its assets.
  • Return on Assets (ROA) Ratio:
    • Measures the ability of the entity to utilize assets to create profits.
  • Return on Equity (ROE) Ratio:
    • Measures the return generated for both common and preferred shareholders.

Liquidity Ratios

Liquidity measures an entity's ability to meet its short-term obligations. An entity that cannot meet these obligations may be forced into liquidation.

  • Current Ratio:
    • Determines short-term debt-paying ability.
    • Focuses on the relationship between current assets and current liabilities.
    • Traditional Benchmark: 2.002.00.
    • A decreased current ratio indicates lower liquidity.
    • Industry averages provide a contextual benchmark for inter-firm comparison.
  • Quick Ratio (Acid Test Ratio):
    • Measures the immediate liquidity of the firm by relating the most liquid assets to current liabilities.
    • Exclusions: Excludes inventory. A more conservative variation may also exclude other current assets that do not represent current cash flow.
    • Traditional Benchmark: 1.001.00.
  • Accounts Receivable Turnover Ratio:
    • Indicates the liquidity of receivables.
    • Measures the number of times receivables are "turned over" (collected) per year.
  • Inventory Turnover Ratio:
    • Measures the adequacy of inventory and the efficiency of its management.
    • Expresses how many times the average inventory balance was sold and replaced during the year.
  • Working Capital Ratio:
    • Measures the capital available for day-to-day trading operations.
  • Cash Ratio:
    • Measures company liquidity by calculating the ability to repay short-term debt specifically with cash.

Financial Stability Ratios

Financial stability relates to the entity’s ability to continue operations in the long term, satisfy long-term commitments, and retain sufficient working capital for successful operation.

  • Debt Ratio:

    • Indicates the percentage of assets financed by creditors.

  • Equity Ratio:

    • Helps determine how well creditors are protected in case of insolvency.
    • Mathematical Relationship:Debt Ratio+Equity Ratio=1 (or 100%)\text{Debt Ratio} + \text{Equity Ratio} = 1 \text{ (or 100\%)}

  • Debt to Equity Ratio:

    • Assists in determining creditor protection during insolvency.

  • Times Interest Earned (TIE) Ratio:

    • Indicates a company’s ability to pay its debt obligations.
    • A higher ratio indicates more cash remains after paying debts.
    • Acceptable Risk: A ratio >2.5> 2.5 is considered acceptable.
    • High Risk: A ratio <2.5< 2.5 indicates higher risk for bankruptcy or default.

Limitations of Financial Analysis

While analytical techniques provide insights, they possess several inherent limitations:

  • Basis in History: Analysis is performed on historical data primarily to forecast future performance.
  • Measurement Base: The calculation of measures often relies on historical cost.
  • Timing Issues: Year-end data may not be representative of the entity's financial position throughout the entire year.
  • Disclosure Gaps: A lack of disclosure in general-purpose financial reports can inhibit the depth of analysis.
  • Non-recurring Items: One-off items (e.g., losses from floods) in the profit or loss statement can distort trends and business efficiency assessments.
  • Information Modifications: Data in general-purpose reports may be subject to supplementations or qualifications in directors' and auditors' reports.
  • Comparability: Different entities may not be directly comparable due to varying accounting methods or structures.

Capital Markets Research and Financial Statement Analysis

Research into the efficiency of share markets has questioned the assumptions underlying fundamental financial analysis:

  • Market Efficiency: Research assumes share markets incorporate all publicly available information into the share price of an entity.
  • Portfolio Diversification: Investors are encouraged to diversify their portfolios to spread risk in case of individual investment failure.
  • Analysis Utility: Some researchers suggest a level of "futility" in deep fundamental analysis, though many people still believe they can achieve significant gains using analysts.
  • Role of Analysts: If markets are efficient, it may be because analysts study publicly available information very closely.
  • Evidence Inconsistency: Capital markets research is not conclusive; some strategies suggest that "abnormal profits" can still be made through the analysis of publicly available information.

Summary of Key Areas

The study of ratio analysis involves:

  • Obtaining entity information for performance and financial position analysis.
  • Utilizing various analytical techniques (horizontal, trend, and vertical analysis).
  • Conducting ratio analysis across profitability, liquidity, and financial stability.
  • Understanding the interactions between these three categories.
  • Interpreting ratio information specifically provided by the statement of cash flows.
  • Acknowledging the limitations of traditional analysis and the impact of capital market research.