Ratios Used in Companies' Financial Analysis - Essay Example

On the other hand, the limitations related to the use of financial ratios include:

• it cannot be used to compare the financial performance of companies belonging to different sectors. Each company belonging to a different sector has different nature of business, market conditions, and regulations, therefore it is not appropriate to compare the financial performance of companies from different industries or sectors (Helfert, 2001);
• it gives an analysis of past performance only and is unable to forecast what is expected in the future (Helfert, 2001).

In this report, the author has used various financial ratios in order to compare the financial performance of companies selected for analysis. The financial ratio analysis includes the comparison of the financial performances of the UK three companies from the retail sector and three companies from the oil and gas sector. In this regard, the following are the ratios that have been considered to conduct the analysis:

Liquidity Ratios
In order to analyze the liquidity position of the selected companies over a period of five years, the current ratio and cash ratio have been determined for each company for each of the five financial years under consideration. By determining these ratios, it is possible to analyze the ability of companies being analyzed to pay off their liabilities (Helfert, 2001). The ratios used in this regard include the current ratio and cash ratio.

Current Ratio

=

Net Income

Capital Employed (Average Debt Liabilities + Average Shareholders’ Equity)

Cash Ratio

=

Cash + Cash Equivalents + Invested Funds

Current Liabilities

Profitability Ratios
For determining the profitability of the selected companies, profitability ratios have also been considered. The ratios included in this analysis are “return on capital employed” (ROCE) and “return on equity” (ROE) (Helfert, 2001). The return on capital employed shows the overall profit earned by a company while making use of its total capital or resources. On the other hand, the return on equity shows the profits earned with respect to total equity held by a company (Helfert, 2001).

Return on Capital Employed

=

Net Income

Capital Employed (Average Debt Liabilities + Average Shareholders’ Equity)

Return on Equity

=

Net Income

Average Shareholders’ Equity

Debt Ratios
Debt ratios are determined to analyze the performance of the company in relation to its debt and the composition of debt in its capital. The report includes the following two ratios to evaluate the debt composition of the companies and operating cash flows with respect to the total debt of the company (Helfert, 2001). The formulae for these two ratios are as follows:

Cash Flow to Debt Ratio

=

Operating Cash Flow

Total Debt

Capitalization Ratio

=

Long Term Debt

Long Term Debt + Shareholders’ Equity

Operating Performance Ratios
The operational performance of a company is an important indicator of the efficiency and effectiveness with which it carries out its operations. In this regard, the analysis includes the calculation of operating cycle and sales revenue per employee for each of the selected companies (Helfert, 2001).

Operating Cycle (Days) = DIO + DSO – DPO

DIO = Days Inventory Outstanding
DSO = Days Sales Outstanding
DPO = Days Payable Outstanding

Sales / Revenue Per Employee

=

Revenue

Number of Employees (Average)

Investment Performance Ratios
In order to determine whether the companies being analyzed in this report are suitable for investment, price-earnings to growth ratio and dividend yield are considered. These ratios are indicative of the potential for investment in these companies. The dividend yield shows the amount of dividend paid by a company in relation to the market price of its shares (Helfert, 2001). These ratios are calculated by using the following formulae:

PEG Ratio

=

Price / Earnings (P/E) Ratio

Earnings Per Share (EPS) Growth

Capitalization Ratio

=

Long Term Debt

Long Term Debt + Shareholders’ Equity