This paper examines financial ratio analysis by defining, the three groups of stakeholders that use financial ratios, the five different kinds of ratios used and their applications, the analytical tools used in analysis, and finally financial ratio analysis limitations and benefits. The paper illustrates that financial ratio analysis is an important tool for firm’s to evaluate their financial health in order to identify areas of weakness so as to institute corrective measures.While financial ratio analysis does contain limitations that include little theory to guide them as well as the use of accounting data based on historical costs that may not reflect a firm’s true economic conditions, it is an excellent tool for different stakeholders to use for different goals that will remain in use in the area of financial management.
Companies prepare and furnish financial statements on a regular basis to their stakeholders that report on their financial standing.However, the accounting information by itself is not easily analyzable and effective in determining how a particular company is doing financially by itself or in relation to others in the industry. Financial ratio analysis is the use of financial statements to evaluate a company’s overall performance and assess its strength and shortcomings (Jiambalvo, 2009). It is a tool used to evaluate the overall financial health of firms and is approached from different perspectives by creditors, managers, and stockholders.The three different groups are all interested in the profitability of the firm but take on different perspectives. Stock holders invest in firms with the intention of maximizing the value of their stock, earning dividends, and generally maximizing their return on investment.
Managers are responsible for the day to day running of the firm and have a fiduciary responsibility to the owners to make decisions that are in the owner’s best interests.They are therefore interested in the same performance measures as stockholders; profitability, dividends, capital appreciation, and return on investment among other measures (Jiambalvo, 2009). Managers make day to day decisions in the running of the firm and as a result need to evaluate the impact of their decisions to ensure maximization of stockholder wealth.Financial statement analysis is a tool used my managers to evaluate the impact of hese day to day decisions. Creditor’s primary concern is whether they will receive interest payments they are entitled to and when they will be paid the money loaned to the firm. Therefore creditors carefully monitor the debt leverage on a firm and whether the firm is generating cash to cover the day to day payments, obligations, and interest and principal payments on long-term debt (Jiambalvo, 2009).
Financial ratios are divided into five categories mainly liquidity ratios that measure the ability of a company to cover its current bills, Efficiency ratios that tell how efficiently a firm is using it assets, Leverage ratios that tell the amount of debt a firm contains in its capital structure and whether it’s able to meet its long-term financial obligations, profitability ratios that focus on a firms earnings and Market value indicators that look at a company based on market data as opposed to historical data used in financial statements (Jimbalvo, 2009).An important analytical tool that uses financial ratios was developed by Edward I. Altman, Ph. D, known as the “Z score”. It uses five traditional financial ratios mixed with multiple discriminant analysis (IOMA’s report, 2003). Professor Altman, a financial economist and professor at New York University’s stern school of business, developed the model by studying financially troubled manufacturing firms but the model works as well on non-manufacturing firms.
The Z score is proven to be 90% accurate in predicting whether a business will fail within a year – and 80% accurate in predicting failure within two years (IOMA’s report, 2003).The Z score formula uses five financial ratios, some being more significant than others. One is Working capital to total assets ratio that measures a firm’s ability to pay off its short-term liabilities and is calculated by subtracting current liabilities from current assets divided by total assets. The retained earnings to total assets ratio that measures a firm’s use of its total asset base to generate earnings is also used.
It is important to note that retained earnings can be easily manipulated distorting the final calculation.The third financial ratio used by the Z score formula is the market value of equity to book value of debt. This is the inverse of the debt to equity ratio, and it shows the amount a firm’s assets can decline in value before liabilities exceed assets. For closely held firms, stockholders’ equity or total assets less total liabilities can be used but this amount has not been statistically verified for purposes of the formula. The sale to total assets ratio that measures a firm’s ability to generate sales with its asset base is also used.
The fifth financial ratio is the operating income to total assets. This ratio is the most important factor in the formula because its profit that eventually makes or breaks a firm. In calculating the Z score, each of these ratios is given a weight factor that is used within the formula. (IOMA’s report, 2003).
See appendix I for the Z score formula and how to interpret the results obtained. The Z score is used by firms when running regular financial data and firms use it to spot financial trouble in time to avoid drastic measures to restore the company’s financial health.Although the Z score is a time-tested way to predict financial insolvency, it must be used with care and as with any analytical tool, it should not be the sole determinative measure (IOMA’s report 2003). The DuPont company developed a system in the 1960s that puts together some of the most financial ratios and provides a systematic approach to financial system analysis. (Jiambalvo, 2009).
The DuPont system is a diagnostic tool that uses financial ratios to evaluate a firm’s financial health. The process of analysis can be broken down into three steps. First, management assesses the firm’s financial health using the DuPont ratios.Second, when any problems are identified, management corrects them, and thirdly, management monitors the firm’s financial performance over time, looking for differences from ratios established as benchmarks by management (Jiambalvo, 2009).
Under the DuPont system, management is responsible for making decisions that maximize the firm’s return on equity as opposed to maximizing the value of stockholder’s shares. The system is primarily designed to be used by management as a diagnostic and corrective tool, but it’s not limited to them only as investors and other stakeholders also use it to diagnose the financial state of a firm.The DuPont system is derived from two equations that link the firm’s return on assets (ROA) and return on equity (ROE). The system identifies three areas where management should focus its efforts in order to maximize the firm’s return on equity mainly how much profit management can earn on sales, how efficient management is in using the firm’s assets, and how much financial leverage management is using. All three areas are monitored by a single ratio, and together the ratios comprise the DuPont equation (Jiambalvo, 2009).
The return on asset equation illustrated in appendix II provides managers the insights that if they want to increase the firm’s return on assets, they can increase the net profit margin, total asset turnover or both. Firm performance is usually measured by profitability which may itself be proxied using the return on assets ration that is defined as the quotient of net profit after taxes to total assets. Though every industry is different, competition, marketing considerations, technology, and manufacturing capabilities place upper limits on asset turnover and net profit margins and thus return on assets.The DuPont equation, noted in appendix III illustrates that a firm’s return on equity on the other hand is determined by three factors namely, net profit margin which measures a firm’s operating efficiency and how it manages its interest expense and taxes, total asset turnover which measures the efficiency with which the firm’s assets are utilized and the equity multiplier which measures the firm’s use of financial leverage (Jiambalvo, 2009).
While calculating financial ratios is helpful, they need a medium in which to be evaluated.Bench marks provide standards of comparison between competing firms of roughly the same size that are in the same type of business through industry, peer group and trend analysis (Jiambalvo, 2009). Trend analysis uses the history of a firm’s performance over time to allow management whether a given ratio value has increased or decreased over time and whether there has been an abrupt shift in a ratio value. An increase or decrease in a ratio value is in itself neither good nor bad.
However, a ratio value that is changing typically prompts the financial manager to sort out the issues surrounding the change and to take any action that is warranted (Jiambalvo, 2009). Another way to establish a benchmark is to conduct an industry group analysis. This is done by taking a number of firms that have the same product line for example, Giant, Safeway, and Food lion that compete in the same market and are about the same size. The average ratio values of these firms are then used as the industry benchmarks.
The third way to establish a benchmark is by peer group analysis where a group of firms that compete with the firm being analyzed is identified. These firms are similar in line of business and are direct competitors of the target firm. Such firms form a peer group and management can obtain their annual reports and compute average ratio values against which the firm can compare its performance. (Jiambalvo, 2009). Ratio analysis does not only benefit users but contains limitations as well.
For one, large firms operate different divisions in different industries.For such firms, it is often very difficult to find a meaningful set of industry-average ratios to use as representative bench marks (http://www. investopedia. com, 2009).
Seasonal factors can also distort ratio analysis. Understanding seasonal factors that affect a business can reduce the chance of misinterpretation. For example, if we consider businesses such as Walmart or Target, their inventories may be considerably higher during the summer high in preparation for the back-to-school season.As a result, their accounts payable will be high and as a result the return on asset ratio would be low (http://www. investopedia. com, 2009).
Another limitation observed with financial ratio analysis is that the analysis depends on accounting data which is based on historical costs. Ratio analysis based on financial statements at historical cost does not reflect a firm’s true economic conditions (Jiambalvo, 2009). A major limitation is the lack of theory to guide users in making judgments based on financial ratio analysis.This lack of theory explains why rules of thumb are often used as decision rules in financial statement analysis. The challenge with decision rules based on experience and “Common sense” rather than theory is that they may work fine in stable economic environments but may fail when a significant shift takes place (Jiambalvo, 2009). The benefits of financial ratios are many.
For one, in today’s tumultuous economy, the stakes are very high in accurately assessing a potential or current customer’s credit worthiness. For firms to be profitable, they must not only sell their products but also get paid.Analyzing a customer’s creditworthiness requires carefully scrutinizing up-to-date and if possible, audited financial statements to extract valuable information from them in order to spot potential warning signs. The most commonly used technique for analyzing financial statements is ratio analysis and financial ratios are used as a relative measure that facilitate the evaluation of efficiency or the condition of a particular aspect of a company’s financial health. Ratio analysis facilitates the calculation and interpretation of financial ratios in order to make that assessment (IOMA report, 2009).In considering the efficiency ratio in relation to the banking industry, it is attractive because it is intuitive and therefore easily understood.
For example 70% ratio implies that it costs 70 cents to generate every dollar of revenue. In the case of the banking industry’s aggregate efficiency ratio trend demonstrates the measures analytical power. For instance, the savings bank industry’s efficiency ratio went from 75% in 1990 to 56% in the first half of 2000, which explains the industry’s improved financial performance in those years (Community banker, 2001).Another benefit is that Ratio analysis is an excellent method for determining the overall financial condition of firms. It puts the information from a financial statement into perspective, helping to spot financial patterns that may threaten the health of firms. Ratios are also very useful for making comparisons between your business and other businesses in your industry.
For example, comparing ratios can indicate whether a business is holding too much inventory or collecting receivable too slowly. This comparison provides a window into ways in which your business can improve its operations (http://www133. americanexpress. com).
