Financial Ratios Used in the Financial Statements and Policies - Coursework Example

Financial Ratios Introduction Financial ratios, often called accounting ratios are used in the financial analysis by comparing two financial items extracted from the financial statements. Financial ratio is defined as “The relationship between two accounting figures expressed mathematically”. The financial ratio helps to find out the performance of the firm over the years and its state of affairs. It used to analyze the functional effectiveness of the firm comparing with the competing firms. Financial ratios help to compute various financial statements and formulate new business-investment policies or to arrive at any management decision. The financial statement prepared with the help of financial ratios is an aid to find out the efficient operation of the business for the share holders, competitors, and outsiders who are willing to invest in the firm. These ratios play a key role in calculating the dividend to shareholders, interest to debenture holders, as well as the tax payable to government. They also express the risk factor and bankruptcy chances of the firm. Theory of Financial Ratios There have been no convincing theories on financial ratios over the years. Horrigan (1965), writes on how the financial ratios were originated and how the theories were not. He says that a unique outcome of the accounting evolution in the United States was the development of financial ratios which helped in analyzing accounting statements. Such ratios were originally formulated for using as short-term credit analytical devices. The origin of such ratios can be traced out as far back as the late 19th century. A number of various financial ratios were developed by the analysts in the early decades of the century. The next step after the formulation of such ratios was the development of body of empirical generalization about such financial ratios which later turn out to be the hypothesis for drawing out theory of financial ratio analysis. However, the materialization of a system of empirical generalization never happened, much less a theory (Horrigan, 1965). Sources of Information for the Calculation of Financial Ratios There are a number of sources for the collection of the information for financial ratio analysis. The Profit and Loss Account and the Balance Sheet serves as the main source for information. Some of the most commonly used sources for accumulating information for analysis are given below. Trial Balance Trading Account Profit and Loss Account Profit and Loss appropriation Account Income Statement Cash-flow Statement Fund-flow Statement Balance Sheet Bank Statements Categories of Financial Ratios. There are numerous financial ratios used in the financial statements and policies. These ratios are categorized on the basis of information they give. Some of the frequently used ratios are: Profitability ratios, Dividend Policy ratios, Asset turnover ratio, Liquidity ratio and Leverage ratio. Profitability Ratio: - The profitability ratio expresses the success of the firm and the profit margin of the firm. The profitability ratio includes Gross Profit Margin, Return on Asset (ROA), Return on Equity (ROE), etc. The gross profit margin is used to determine the gross profit earned over sales, considering only the cost of goods sold and excluding all other items. Gross Profit Margin = Sales – Cost of goods Sold Sales Dividend Policy Ratios: - The dividends to the share holders are paid out in the most suitable way using the dividend Policy Ratios. The generally used ratios are Dividend Yield Ratio and Payout Ratio. Dividend Yield Ratio = Dividend per Share Share Price Payout Ratio = Dividends per Share Earnings per Share Asset Turnover Ratios: - The efficiency in utilizing the assets of the business is pointed out by the Assets Turnover Ratios. One of the commonly used Asset Turnover ratios is Receivables Turnover ratio indicating the speed of collecting the accounts receivable of the firm. Receivables Turnover Ratio = Annual Credit Sales Account Receivable Liquidity Ratios: - The liquid cash available with the firm is calculated using Liquidity ratios. It indicates the firm’s capacity to meet its short-term financial obligations. Liquidity Ratios enables to asses the ability of the firm to raise money in a critical or adverse situation. Current Ratio and Quick Ratios are commonly used to find out the liquidity of the firm. Current Ratio = Current Assets Current Liabilities Leverage Ratio: - Leverage Ratios helps to find out how the firm is using the long term debts. It explains the capacity of the firm regarding the long-term solvency. The frequently used leverage ratios are Debt Ratio and Debt-to-Equity Ratio. Debt-to-Equity Ratio = Total Debt Total Equity There should be reasonable care and diligence in putting into practice these financial ratios. For the internal or external evaluation of the firm these ratios acts as effective and useful tools for management. DuPont Identity: - DuPont Identity other wise known as DuPont equation or DuPont Method is a formula which divides the ROE (Return on Equity) into three parts, namely Net Profit Margin, Asset Turnover, Equity Multiplier. The name DuPont came into existence from the DuPont Corporation which started sing this formula since 1920. ROE (Return on Equity) = Net Profit Margin X Asset Turnover X Equity Multiplier = Net Profit / Equity (i) Net Profit Margin: - The Net Profit Margin brings out the percentage of profit earned by the firm on each dollar of revenue it receives. There are differences in the profit margins of competing firms, but the higher the ratio better the position. Profit Margin = Net Profit / Sales (ii)Asset Turnover: - The efficiency of the firm in utilizing their assets to generate income is computed using Asset Turnover Ratio. Efficacy of Asset Turnover tends the decisions of an investor. Asset Turnover = Sales / Assets (iii)Equity Multiplier: - Financial leverage of the firm is brought into light by Equity Multiplier Ratio. A close watch on this helps the investor to find out whether the Return on Equity is artificially increased by unnecessary debts. It expresses the debt-equity balancing of the firm. Equity Multiplier = Assets / Equity Uses of DuPont Identity: It bestows a positive sign of the company if the ROE of the company goes up. It means that the company manages itself better and exposes an enlarged face of the firm. The DuPont Identity is very useful to the management as well as outsiders. The information derived out of the DuPont equation can be made use of in targeting the performance the similar type of firms in the industry. The investor gets an opportunity to predict the performance of different companies in comparing their strength and weakness. As a result the investor may less likely tend to invest in a company even if it looks pleasing outside. The company might only have feeble returns out of alarming profit margins or blown up leverage. It helps the investors from investing their money in a company which exposes artificially raised ROE by increasing their leverage with the intention of attracting more investors. Use of Financial Ratios. It is an important factor for consideration that how to be levelheaded in understanding the Financial Ratios. Making sense out of these ratios is as hard as computing the ratios, and to make use of these ratios even harder. There would be variations in the ratios of a firm and the management should react to such deviations taking timely decisions. As Davis and Peles (1993) write, the management fixes or sometimes the external markets force the management to fix an equilibrium value or a target ratio, and if any deviations from the target causes the management to take actions that will return the ratio to target. These Financial Ratios are helpful to the outsiders too. Those who are interested to invest in a firm can take decision on making the most of such ratios and finding the profit margin from the financial statements. Another aspect of the ratio investigation helps the analyst to identify whether a firm is going to be declared bankrupt or might default on a loan. For easy understanding and better utilization some of the firms have implemented the division of specific ratios basing on the purpose of the analysis, such as internal liquidity, operating performance, risk analysis, growth analysis, and external market liquidity. The ratios help also in simplifying the accounting information as they discuss a brief summary of the detailed and complicated computations. Therefore there it does not create problem for a non-professional person to understand the efficiency of the firm. It is useful in checking out the short- and long-term financial position. Limitations As there are numerous uses of financial ratios there are number of limitations too. One of the main limitations is that in the ratio analysis, the qualitative factors are completely ignored and gives important only to quantitative facts. Ratio analysis often becomes just a window-dressing and cannot be relied on. Many ratios posses limited comparability. The ratios are not being able to be compared as different methods accounting are maintained in different firms. A company maintaining stock in FIFO method cannot be compared with a company which maintains stock in LIFO method. Though there are such limitations, the precise and brilliant formulation and application of Financial Ratios can bleach out its limitations. References Alexander, C. V. Analysis of Financial Ratios. Retrieved from http://cab.org.in/Lists/Knowledge%20Bank/Attachments/85/Financial%20Ratios.pdf Davis, H. Z & Peles, Y. C. “Measuring Equilibrating forces of financial ratios”. The Accounting Review. 68, (4), 725-747. Horrigan, J. O. (1965). “Some Empirical basis of financial ratio analysis”. The Accounting Review, 40 (3). 558. Read More