Ratio Analysis

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Contents
• 1 Profitability
• 2 Financial or Liquidity ratios
• 3 Activity or Management Efficiency ratios
• 4 Market or Investment ratios

• 5 Limitations of ratios and potential impact in the analysis

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WIKI ANALYSIS
This article is part of WikiProject Definitions. Consider editing to improve it. View
articles referencing this definition.

TOP CONTRIBUTORS
George Michaelides

Financial Ratio Analysis is the calculation and comparison of main indicators - ratios
which are derived from the information given in a company's financial statements(which
must be from similar points in time and preferably audited financial statements and
developed in the same manner). It involves methods of calculating and interpreting
financial ratios in order to assess a firm's performance and status. This Analysis is
primarily designed to meet informational needs of investors, creditors and management.
The objective of ratio analysis is the comparative measurement of financial data to
facilitate wise investment, credit and managerial decisions. Some examples of analysis,
according to the needs to be satisfied, are:

• Horizontal Analysis - the analysis is based on a year-to-year comparison of a

firm's ratios,
• Vertical Analysis - the comparison of Balance Sheet accounts either using ratios
or not, to get useful information and draw useful conclusions, and
• Cross-sectional Analysis - ratios are used and compared between several firms of
the same industry in order to draw conclusions about an entity's profitability and
financial performance. Inter-firm Analysis can be categorized under Cross-
sectional, as the analysis is done by using some basic ratios of the Industry in
which the firm under analysis belongs to (and specifically, the average of all the
firms of the industry) as benchmarks or the basis for our firm's overall
performance evaluation.

The informational needs and appropriate analytical techniques needed for specific
investment and credit decisions are a function of the decision maker’s time horizon(short
versus long term investors and creditors). A pervasive problem when comparing a firm’s
performance over time(trend or time series analysis) or with other firms(cross sectional
or common size analysis) is changes in the firm’s size over time and the different sizes of
firms which are being compared. However, one approach to this problem is to use
common size statements in which the various components of the financial statements are
standardized by expressing them as a percentage of some base (base in the income
statement is sales and base in the balance sheet is total assets). See sample file below for
further understanding.

In general, a process of standardization is being achieved by the use of ratios. They can
be used to standardize financial statements allowing for comparisons over time, industry,
sector and cross-sectionally between firms and further facilitate the evaluation of the
efficiency of operations and/or the risk of the firm’s operations regarding the scope and
purpose of evaluation. Ratios measure a firm’s crucial relationships by relating
inputs(costs) with output(benefits) and facilitate comparisons of these relationships over
time and across firms.
Many attractive categories of financial ratios and numerous individual ratios have been
proposed in the literature. The most prominent literature on financial analysis - though
non-exhaustive - indicates the following categories of ratios:

Profitability

• Gross Profit ratio = ( Gross profit / Sales ) * 100

• Operating Profit = ( Operating profit / Sales) * 100
• ROCE - Return on Capital Employed, in times = ( Profit before interest and tax /
Net Assets )

Financial or Liquidity ratios

• Current ratio, in times = ( Current Assets / Current Liabilities )

• Quick ratio, in times = ( (Current Assets - Stock) / Current Liabilities )
• Gearing ratio = ( Long Term Liabilities / (Total Capital and Reserves + Long term
Liabilities ), either in times or as a percentage by multiplying by 100.
• Interest Cover, in times = ( Operating profit / Interest expense )

Activity or Management Efficiency ratios

• Debtors days, in days = ( Av. Debtors / Sales ) * 365

• Creditors days, in days = ( Av. Creditors / COGS ) * 365, where COGS is the
Cost of Goods Sold by the firm
• Stock days, in days = ( Av. Stock / COGS ) * 365

Where "Av.", is the Average amount of the opening and closing balance of the
corresponding account of the financial year the Analysis is being undertaken.

Market or Investment ratios

• Dividend cover, in times = ( Profit after tax / dividends )

• Dividend yield = ( Dividend / Share price )
• P/E = ( Share price / Earnings per share )

Each category can be further utilized and an in-depth analysis can be adopted to reflect
the corresponding needs of each user, i.e. a bank considering whether to lend a specific
company would focus more on financial and liquidity - as the risk of lending to a
company that does not have the resources to repay the loan is of great concern for a bank
- and profitability ratios, to see whether the company's earnings are adequate to cover the
interest on the loan. An analysis from an investor's point of view on the other hand would
focus more on profitability and investment ratios, to evaluate the prospects of his
potential returns.
Note that there is no absolute guidance or specific definition of ratios and therefore
special consideration should be undertaken when ratios are used to make comparison
either in a cross-sectional analysis or Inter-firm (as described above).

Limitations of ratios and potential impact in the analysis

• Ratios are not predictive, as they are usually based on historical information
notwithstanding ratios can be used as a tool to assist financial analysis.
• They help to focus attention systematically on important areas and summarise
information in an understandable form and assist in identifying trends and
relationships (see methods for facilitating the financial analysis above).
• However they do not reflect the future perspectives of a company, as they ignore
future action by management.
• They can be easily manipulated by window dressing or creative accounting and
may be distorted by differences in accounting policies.
• Inflation should be taken into consideration when a Ratio Analysis is being
applied as it can distort comparisons and lead to inappropriate conclusions.
• Comparisons with industry averages is difficult for a conglomerate firm since it
operates in many different market segments.
• Seasonal factors may distort ratios and thus must be taken into account when
making ratios are used for financial analysis.
• Not always easy to tell that a ratio is good or bad. Must be always used as an
additional tool to back up or confirm other financial information gathered.
• Different operating and accounting practices can distort comparisons.
• Using the average of certain ratios for companies operating in a specific industry
to make comparisons and draw conclusions may not necessarily be a indicator of
good performance; perhaps a company should aim higher.