Financial Ratio Analysis and Interpretation Notes

Financial Ratio Analysis

Financial ratio analysis is a technique used to compare relationships between financial data items from a company's financial statements. It facilitates fair comparisons across time, between different companies, or across industries.

Liquidity Analysis

Liquidity analysis assesses a company's ability to meet its immediate debt obligations using its current assets. Key ratios include:

Current Ratio

The current ratio is calculated as current assets divided by current liabilities: CurrentRatio=CurrentAssetsCurrentLiabilitiesCurrent Ratio = \frac{Current Assets}{Current Liabilities}. It evaluates an entity’s liquidity and short-term debt-paying ability. A higher ratio is generally more favorable.

  • Example: For Harrison, a current ratio of 0.91 means that for every dollar of current liabilities, the company has 0.910.91 of current assets, suggesting potential difficulty in meeting short-term obligations. Generally, a ratio of around 1.5:1 is considered acceptable for most industries.
Quick Ratio

The quick ratio, also known as the acid-test ratio, measures an entity’s immediate short-term liquidity. It is calculated as (current assets minus inventory) divided by current liabilities: QuickRatio=CurrentAssets−InventoryCurrentLiabilitiesQuick Ratio = \frac{Current Assets - Inventory}{Current Liabilities}. This ratio excludes inventory and prepaid expenses, focusing on the most liquid assets.

  • Example: Harrison's quick ratio increased marginally from 0.26 to 0.27. A general guideline is that a ratio of approximately 1:1 is considered adequate.

Solvency Analysis

Solvency analysis evaluates a company’s ability to pay off all its debts using its income, assets, and equity.

Debt to Total Assets Ratio

The debt to total assets ratio measures the percentage of total assets financed by creditors. It is calculated as total liabilities divided by total assets: DebttoTotalAssetsRatio=TotalLiabilitiesTotalAssetsDebt to Total Assets Ratio = \frac{Total Liabilities}{Total Assets}. This ratio indicates the degree of leveraging and the entity’s ability to withstand losses.

  • A higher ratio indicates greater financial risk, while a lower ratio suggests more equity is available to creditors if the entity becomes insolvent.
  • Example: Harrison’s debt to total assets ratio of 0.58 indicates that creditors provided 58 cents for every dollar invested in assets.
Times Interest Earned

Times interest earned, also known as interest coverage, indicates the entity’s ability to meet interest payments. It is calculated as earnings before income tax plus interest expense divided by interest expense: TimesInterestEarned=EarningsBeforeIncomeTax+InterestExpenseInterestExpenseTimes Interest Earned = \frac{Earnings Before Income Tax + Interest Expense}{Interest Expense}.

  • A general rule of thumb is that earnings should be approximately 3–4 times the interest expense. Higher figures indicate a stronger ability to cover interest expense.

Profitability Analysis

Profitability analysis assesses a company’s ability to generate profit from its goods or services.

Return on Assets

The return on assets (ROA) measures the overall profitability of assets. It is calculated as profit divided by average total assets: ReturnonAssets=ProfitAverageTotalAssetsReturn on Assets = \frac{Profit}{Average Total Assets}.

  • A higher ROA indicates a more profitable entity.
  • Example: Harrison’s return on assets was 10 cents for each dollar of assets, higher than the 6 cents in the previous year.
Profit Margin

The profit margin, or rate of return on sales, measures the amount of each dollar of sales that results in profit. It is calculated as profit divided by net sales: ProfitMargin=ProfitNetSalesProfit Margin = \frac{Profit}{Net Sales}.

  • Example: Harrison’s profit margin indicates that 4 cents of profit were generated from each dollar of sales.

Efficiency Analysis

Efficiency analysis evaluates how well a business is using its assets on behalf of its owners. Key ratios include:

  • Inventory-turnover ratio: InventoryTurnoverRatio=SalesInventoryInventory Turnover Ratio = \frac{Sales}{Inventory}
  • Days-sales outstanding: DaysSalesOutstanding=AccountsReceivableAverageSalesPerDayDays Sales Outstanding = \frac{Accounts Receivable}{Average Sales Per Day}.
    • Also known as the average collection period.
  • Fixed-assets-turnover ratio: FixedAssetsTurnoverRatio=SalesNetFixedAssetsFixed Assets Turnover Ratio = \frac{Sales}{Net Fixed Assets}
  • Total-assets-turnover ratio: TotalAssetsTurnoverRatio=SalesTotalAssetsTotal Assets Turnover Ratio = \frac{Sales}{Total Assets}

Interpretation of Financial Statements

Horizontal Analysis

Horizontal analysis evaluates financial statement data over a period to determine increases or decreases, expressed as amounts or percentages. The formula to calculate percentage change from the base year is: CurrentYearValue−BaseYearValueBaseYearValue\frac{Current Year Value - Base Year Value}{Base Year Value}

  • Example: Harrison Ltd's total group sales increased by approximately 4% from 2015 to 2016 and by approximately 18% from 2015 to 2019.
  • Horizontal analysis should be supplemented with inter-company comparisons, economic conditions, industry trends, and information from directors’ reports and media releases.

Vertical Analysis

Vertical analysis evaluates financial statement data by expressing each item as a percentage of a base amount (e.g., selling expenses as a percentage of total revenue in the income statement or current assets as a percentage of total assets in the statement of financial position).

  • Vertical analysis is enhanced by including general economic conditions, industry trends, and information from web sites, directors’ reports, and media releases.

Common Size Analysis

Common size analysis, also referred to as vertical analysis, evaluates financial statements by expressing each line item as a percentage of a base amount for the period.

Common size financial statement analysis is computed using the following formula: LineItemBaseAmount\frac{Line Item}{Base Amount}

Types of Common Size Analysis
  • Vertical analysis: Analyzes specific line items in relation to a base item within the same financial period.
    • Example: Assessing the proportion of inventory by dividing the inventory line by total assets.
  • Horizontal analysis: Compares specific line items to a similar line item in the previous or subsequent financial period.
Balance Sheet Common Size Analysis

The total assets value is commonly used as the base value. It helps compare a firm’s capital structure to rivals.

  • Example: A high value of long-term debt in relation to the total assets value may signal potential distress.
Income Statement Common Size Analysis

The base item is usually total sales or revenues. Common size analysis is used to calculate net profit margin, as well as gross and operating margins.

  • Example: Analyzing ABC Company's income statement to see that 10% of revenues are spent on research and development and 3% on advertising.

Trend Analysis

Trend analysis is an analytical method used to interpret patterns in data to forecast future financial statements. It involves analyzing the direction and amount of change.

  • Example: Sales for Colgate increased by 16.3% over eight years whereas the overall net profit decreased by 20.3% over the same period. It is crucial to properly analyze past events before using trend analysis to make decisions.