Using a Large Number of Ratios to Perform a Complete Ratio Analysis of a Firm - Essay Example

?Describe how you would use a large number of ratios to perform a complete ratio analysis of a firm. Discuss the pros and cons of these ratios. Introduction The ratios can be divided into various categories such as profitability, gearing and liquidity, each focusing on a different area of the financial outlook of the organization and highlighting the company’s performance. These analysis form an integral part of the financial statement analysis, especially from the investors point of view, who always strive to invest in countries having strengthen and stabilizing financial ratios and representing an upward trend. It is of great significance that the ratios must be benchmarked against a standard in order for them to possess a meaning. Keeping that into account, the comparison is usually conducted between companies portraying same business and financial risks, between industries and between different time periods of the same company. Profitability Ratios Gross profit margin is an analyzing tool which assists in identifying how effectively and efficiently the company is utilizing its raw materials [1], variable cost related to labor and fixed costs such as rent and depreciation of property plant and equipment. The ratio is calculated by dividing the sales revenue by the gross profit. Net profit margin, on the other hand analyzes the profitability of the company before deducting the taxation and finance charges from the earnings. The ratio is calculated by dividing the profit before interest and tax with the sales revenue of the current financial period. The ratio highlights how well the company is managing its selling and administrative expenses it also highlights the other income generated by the company during the course of its operations. Return on capital employed (ROCE) is, according to the analyst, is considered to be the most significant ratio in order to evaluate a company’s performance from an investor’s point of view. ROCE measures a company’s ability to earn a return on all of the capital that is being employed by the company [3]. The ratio is calculated as net income upon total capital employed, which is the sum of debt and equity financings. Earnings per share (EPS) are considered one of the most important financial ratios from the investor’s point of view. The ratio highlights the average earnings from the shares transacted and is calculated by dividing the profit attributable to the common share holders and multiplying them with the weighted average number of shares outstanding during the period. The liquidity ratio measures the company’s ability to pay its short term liabilities. The ratio illustrates that how quickly a company can convert its assets into cash and cash equivalent in order to pay off its short term liabilities [3]. The most commonly used liquidity ratio, the current ratio, which is calculated by comparing the current assets and current liabilities. The strengthened the current ratio the more ability the company has to pay its debts and short term obligations over the next 12 months. An overall analysis of the ratio would portray that in all the years the company had enough assets to pay off its obligations and debts. The acid test, which is also regarded as the quick ratio, is calculated by subtracting the inventory balance from the total current assert balance. . Out of the current assets mentioned, inventories are regarded as the one which takes comparatively more time to be converted into cash or cash equivalent. Receivable turnover represents how quickly the cash is received from the debtors. The ratio is calculated by dividing the revenue generated from the sales by the receivable balance as mentioned in the balance sheet of the company. The formula calculates the number of times the debtors are turned over during a year. The higher the value the more efficient the management is or it could also mean that the debts are more liquid. Inventory turnover represents how quickly a company’s inventory is sold, which can be calculated by dividing the sales revenue by the average inventory balance as at the year end. High inventory level is not beneficial for the company as it represents that the company’s investment is tied in inventory and currently it is not generating any income. A lower inventory turnover period represents that the sales are poor and there is excess inventory in the storage. Whereas a higher turnover period might represents that sales are comparatively higher. An inventory turnover period can also decreased due to the shift in the operation policy of the management e.g. if the management decides to increase the level of ‘safety stock’ then the balance of closing inventory would be greater and thus inventory turnover period would decrease, although the sales would have increased during the period Gearing Ratios The gearing ratios and indicate the level of risk taken by a company as a result of its capital structure [4]. These ratios are a great source of determining the level of financial risk to which the company is exposed and thus helps in reducing it to the optimum [4]. The equity ratio indicates how much of the entity’s assets are financed through the finances generated through the revenue generated from the operations of the entity and raising financing through equity issue rather than acquiring debts or other financial institution. The debt ratio represents characteristics which is the opposite to that of the equity ratio. Debt ratio, which calculated by comparing the total liabilities to total assets, is a primary tool in determining the influence the company is under as a result of obtaining finances from sources other than equity. A lower ratio represents that the company is utilizing its equity in order to finance its operations and thus curtailing the financial risk. Another ratio to assess the financial leverage of the company is by calculating the borrowing ratio of the company. The ratio is calculated by dividing all the short term and long term borrowing of the company in the form of overdraft, long term loan and finances etc., with the shareholder’s equity. The borrowing ratio presents similar trends as the debt ratio, and also due to the fact that the ratio uses the same dependents. Pros and Cons of Ratio Analysis Ratio analysis is a very accurate and reliable tool when it comes to analyzing the financial outlook of an entity. The primary reason to conduct a ratio analysis is to quantify the results of the operations of a company and compare them with that of the prior year(s) in order to assess different aspects of the financial feasibility. There are certain drawbacks of ratio analysis as well. For instance the ratio analysis fails to interpret the operational stability and health of the operations of the company. This type of analysis also has a limited usage when it comes to predict the future financial situation, although it might be useful in assessing the viability of the business in the shorter run. References [1] Richard Loth “Profitability Indicator Ratios: Profit Margin Analysis.” investopedia.com. Investopedia, n.d. Web. 21 Oct 2012. [2] Rosemary Peavler “Use profitability ratios in financial ratio analysis”Bizfinance.about.com” About.com – a part of the New York Times company, n.d. Web. 21 Oct 2012. [3] Jim Mueller “Diving into financial liquidity” investopedia.com. Investopedia, n.d. Web. 21 Oct 2012. [4] “Gearing ratios” qfinance.com. Bloomsbury information limited, n.d. Web. 21 Oct 2012. [5] “Equity Financing.” investopedia.com. Investopedia, n.d. Web. 21 Oct 2012. [6] Pierre Vernimmen “Corporate Finance – theory and practice” John Wiley & Sons Ltd. Volume 10 [7] Rosemary Peavler “Debt and Equity Financing.” Bizfinance.about.com” About.com – a part of the New York Times company, n.d. Web. 21 Oct 2012. Read More