Ratio Analysis in Comparison of Company in Industry and with Its Chief Competitors - Essay Example

USEFULNESS OF RATIO ANALYSIS IN PROVIDING A MEANINGFUL COMPARISON OF COMPANY WITHIN INDUSTRY OF OPERATION AND WITH ITS CHIEF COMPETITORS Table of Contents Chapter 1: Introduction to Ratio Analysis 4 Chapter 2: Meaning of Accounting Ratios 4 Chapter 3: Types of Ratios 5 Chapter 4: Analysis of Ratios 7 Chapter 5: Uses of Ratio Analysis 8 Chapter 6: Limitations of Ratio Analysis 8 Chapter 7: Looking Beyond Numbers 9 Chapter 8: Recommendation & Conclusion 9 References 10 Chapter 1: Introduction to Ratio Analysis The financial statement of a company aims to provide information about enterprise’s financial position on a given date. Such information helps the decision makers to strategize correct course of action. The decision makers may be internal (management, shareholders, employees, etc.) or external (creditors, investors, government, competitors, etc.) to business enterprise. The financial statements in isolation are not enough to give meaningful information unless it is compared with other financial statements. There are various techniques available for the analysis of financial statements like trend analysis, ratio analysis, common size statements, comparative statements, and cash flow analysis. These techniques help to compare a company’s performance with its chief competitors in same industry as well as monitor the company’s progress over time. Chapter 2: Meaning of Accounting Ratios Accounting ratios is an important tool for financial statement analysis. A ratio is defined as relation between two numbers expressed as fraction or as percentage. When such relationships are derived from the financial statements, they are called accounting ratios (Kim & Ayoun, 2005, p.2). Accounting ratios have immense application in interpretation of financial statements by helping perform both intra-firm and inter-firm comparison. Intra-firm comparison helps to measure the performance of the company on Y-O-Y basis while inter-firm comparison helps to evaluate Company’s performance with its competitors. Chapter 3: Types of Ratios Ratios can be broadly classified into income statement ratios (derived from income statement), balance sheet ratios (derived from balance sheet) and composite ratios (one item from balance sheet and another from income statement). Liquidity Ratios They help to evaluate the firm’s ability to honor its short term or current obligations. It is an indicator for the measure of working capital management. The firms’ short term obligations include carrying out day to day operations, payments to creditors for purchase of raw materials, payment of daily wages of laborers, outstanding expenses and bills payables, etc. These current liabilities are financed by current assets (Bragg, 2012, p.73). Current Ratio The ratio of current asset to current liabilities is defined as current ratio. Quick Ratio It is also known as liquid ratio and is defined as the ratio of quick assets to current liabilities. Quick asset is the current assets less inventories. Debt- Management Ratios These ratios are used to evaluate the company’s ability to evaluate long term obligations and maintaining the safety of principal debt along with timely interest payment. Debt Ratio It is the ratio of total long-term debt to total asset. While a low ratio provides security to creditors a high ratio helps the management to trade on equity. Hence it is also called the leverage ratio (Drake, 2008, p.9). Debt-Equity Ratio It is the ratio of long term debt to shareholders’ fund (Equity shares, retained earnings, preference shares, and fictitious assets). Form the investors’ point of view a low value will imply more security and less chance of insolvency. Profitability Ratios The profitability of a company can be measured in terms of gross turnover or sales or the capital employed, or total assets. It is a key indicator of the company’s performance in its industry of operation. It helps to measure the company’s position. These ratios are mainly derived from the income statement of the company. Some example of profitability ratios are Gross profit Margin, Net profit Margin, Operating Margin, Return on capital employed etc. (Bajkowski, 1999, p.5). Asset Management Ratios The shareholders are the owners of the company but they don’t run the business. In fact the business is run by the managers who manage the resources of shareholders. The assets of the company are managed by the managers and their performance is measured with help of asset management ratios like Fixed Assets Turnover ratio, Debtors (Receivables) Ratios, Creditors (Payables) Ratios, Investment Turnover Ratio, and working capital Turnover Ratio. Chapter 4: Analysis of Ratios Trend Analysis It helps to analyze the performance of company over a period of time using past data. It can help the decision makers understand the pattern of growth or decline in any ratio and take necessary steps accordingly. It can also help in forecasting. Common Size Analysis Two companies may be operating in same industry but their scale of operation, sales turnovers, cost of capital, etc. may be different because of their relative size. This analysis helps in inter-firm comparison by expressing a key variable as a percentage of total sales or asset. This process removes the confusion of scale of operation. Percentage Change Analysis When any company is performing intra-firm comparison it can use this technique to evaluate its Y-O-Y performance. The changes in key variables are expressed as percentage of base year value and multiplied by 100. The result is percentage change over time. Du Pont Equation The basic formula of Du Pont analysis is, It helps to analyze inter-firm comparison of companies in same industry by measuring the source of inferior or superior return. This analysis is only meaningful in manufacturing sector (Soliman, 2008, p.849). Comparative Analysis It shows the financial position of a company over time. Benchmarking It is the comparison of one business with the best business performer in the industry on the basis time, cost or quality. Chapter 5: Uses of Ratio Analysis 1. Ratios are the key indicator to measure the managers’ performance. 2. Ratios help in decision making and controlling firm’s operations. 3. It helps to assess the company’s solvency, profitability, and risk. 4. Helps in SWOT analysis 5. Helps stock analyst to understand company’s efficiency, risk and growth. Chapter 6: Limitations of Ratio Analysis 1. Limitations of accounting data (for instance, the profit of a business is based on the accountant’s opinion which must be audited to get true picture about affairs of company). 2. It ignores price level changes. 3. It ignores qualitative and non-monetary aspects. 4. Different accounting policies like depreciation calculation, stock valuation, etc. are different for businesses. These variations will affect cross-sectional analysis of ratios. 5. Ratio analysis lacks universally accepted standards. 6. Forecasting is done on the basis of historical data which is insignificant due to price level changes with time. Chapter 7: Looking Beyond Numbers Accounting Ratios are not just numbers as they are very useful for inter-firm performance comparison with competitors. It also helps to know the percentage change of company’s business over time. Ratio analysis helps to identify the key areas of business that needs attention like important customers, suppliers, or products, and then help decision makers take necessary steps. Since there are no legal or regulatory guidelines for ratio analysis like the accounting standards, it is completely dependent on the company’s requirements as to how they may use it. Chapter 8: Recommendation & Conclusion Ratio analysis helps the company to identify its key customers and products, which are directly related to a significant portion of company’s revenues. It helps to identify the major suppliers and their credit management. Ratios serve useful purpose when the overall business is compared with its competitors as well as intra-firm comparison. They also help to measure the performance of managers by evaluating how they are utilizing company’s assets. It should be noted that ratio analysis is means and not the end. So lack of ability resolve problems would lead to inconsistent analysis. References Bragg, S. M. 2012. Business Ratios and Formulas: A Comprehensive Guide. John Wiley & Sons, Inc., 2012. Bajkowski, J. 1999. Financial Ratio Analysis: Putting The Numbers To Work. [Online]. Available at: http://www.aaii.com/journal/article/financial-ratio-analysis-putting-the-numbers-to-work. [Accessed on February 15, 2013]. Kim, W. G. & Ayoun, B. 2005. Ratio Analysis for the Hospitality Industry: A Cross Sector Comparison of Financial Trends in the Lodging, Restaurant, Airline and Amusement Sectors. [Online]. Available at: http://scholarworks.umass.edu/cgi/viewcontent.cgi?article=1205&context=jhfm. [Accessed on February 15, 2013]. Drake, P. 2008. Financial Ratio Analysis. [Pdf]. Available at: http://educ.jmu.edu/~drakepp/principles/module2/fin_rat.pdf. [Accessed on February 15, 2013]. Soliman, M. T. 2008. The Use of DuPont Analysis by Market Participants. [Pdf]. Available at: http://faculty.haas.berkeley.edu/kli/papers/Soliman-2008TAR.pdf. [Accessed on February 15, 2013]. Read More