Accounting: Tools for Business Decision Making - Example

RATIO ANALYSIS By of the of the School Introduction Ratio analysis is a tool of financial analysis that is widely used to compare the relationship between risk and returns of firms of different sizes (Kimmel et al 290). It is a systematic use of ratios in interpreting the firm’s financial statements in order to determine its weaknesses and strengths, financial health as well as its current performance and historical performance Dyson, 219). Such relationships between financial statement account aid creditors, investors, and internal management of the firm understand how well and efficiently the firm is performing together with the areas that should be improved (Carlberg & Carlberg, 171). Categories of ratios There are four broad categories of ratios:  liquidity ratios, investment ratios, profitability ratios and efficiency ratios 1. Liquidity ratios Liquidity ratios illustrate the firms ability to meet its near-term obligations. It is the main measure of a firm’s financial health. The two main ratios under this category are acid test ratio and current ratio (Dyson, 223-3). a) Current ratio This is the most fundamental liquidity test. It shows the ability of the business to meet its near-term liabilities using its near-term assets (Kapil, 120). The ratio is calculated as follows Current ratio= current assets/current liabilities A firm’s current assets can satisfy its current liabilities or obligations when it has a current ratio of equal to or more than one. However, the firm has liquidity problems if its current ratio is less than one. b) Quick ratio (acid test ratio) This ratio is a stringent test of liquidity because it eliminates inventory that is not easily converted into cash. The ratio is computed as follows Quick ratio= (current assets-inventories)/current liabilities Acid test ratio measures how well a firm can meet its near-term obligations using its most liquid (quick or near cash) assets. The ratio informs creditors how much a short-term debt of the company can be met when the liquid assets of the company are sold at very short notice. A quick ratio of equal to or more than one indicates that the firm is able to meet its near-term obligations using its quick assets however, a ratio of less than one show that the firm is incapable of meeting short-term obligation thus experiencing liquidity problems (Khan, & Jain, 6.3). 2. Profitability ratios Profitability ratios measure the company’s overall performance and efficiency. Such ratios help investors to gauge the ability of the company to generate earnings or returns using its assets and stockholders’ equity (Kimmel et al 299). The enterprise is said to be performing well if its profitability ratios are higher than those of its competitors or its ratios from the previous period. Some of the ratios under this category are profit margin, operating profit margin, return on assets, return on shareholders equity, gross profit margin and return on equity (Dyson, 223-6). a) Return on assets Return ratios indicate the firm’s ability to measure its overall efficiency in generating returns or earnings for its shareholders. Return on assets ratio, therefore, assesses the efficiency with which the firm manages it investment in assets and employing them to generate profit (Kapil, 127). The ratio is calculated as follows Return on assets (ROA) = net income/total assets ROA measures the amount of profit that is earned relatively to the company’s investment level in total assets. A higher percentage is better because it implies that the firm is using its total assets efficiently to generate sales. b) Gross profit margin This ratio indicates how much profit is earned on the firm’s products without considering indirect costs. It is calculated as: Gross profit margin = gross profit/sales The ratio discloses the efficiency of the firm’s production activities. It shows how efficient and effective the company is in producing products for their customers. A firm is said to be producing at a relatively lower cost if it has a higher gross margin ratio than the industry average (Khan, & Jain, 6.6).. 3. Investment ratios Such ratios are of great importance to prospective investors because they act as investment valuation indicators. Such ratios include dividend yield, dividend cover, earnings per share, price to earnings ratio and gearing ratio (Dyson, 229-31). a) Dividend yield This is the most useful investment ratio. It is calculated as follows: Dividend yield= (dividend per share/market price per share) 100 It measures the rate of return an investor gets from his/her investment in ordinary shares (Investopedia). b) Dividend cover The ratio is computed as follows: Dividend cover = (Net profit-taxation-preference dividend)/ordinary dividends Dividend cover illustrates the number of times an investor is paid ordinary dividends out of the current earnings. It highlights the number of times the earnings cover the dividends. Companies with a dividend cover of two times pays out half of their earnings as ordinary dividends (Kimmel et al 298). 4. Efficiency ratios Ratios under this category measure how effectively the firm is utilizing its assets to generate income and how well it is managing its liabilities. Such ratios are, therefore, used by the company’s management to help improve it. Ratios in this category include stock turnover ratio, fixed asset turnover ratio, trade debtor collection period ratio, and trade creditor payment period (Dyson, 226-9). a) Fixed assets turnover ratio The ratio is calculated as: Fixed assets turnover ratio= net sales/total fixed asset It measures the firms ability to generate sales revenue from fixed asset investments. A higher ratio indicates that the firm is more effective in applying its fixed asset investment to generate revenues. b) Stock turnover ratio This ratio shows how well a firm is managing its inventory levels. Lower inventory turnover is unfavorable because it suggests that the firm is overbuilding or overstocking its inventory. Thus, companies should ensure that they have a higher inventory turnover (Accounting Explained). It is calculated as: Inventory Turnover = (Cost of Sales) / (Average Inventory) (Accounting tools.com) Usefulness of ratio analysis Ratio analysis is a very crucial tool of management accounting. The following are the main uses of ratio analysis i) Simplifying and analyzing financial statements Accounting ratios are helpful in understanding the company’s financial position. Different stakeholders use the ratios to analyze a company’s financial situation for the purposes of decision making. Ratio analysis converts the raw information in the financial statements into useful information that is helpful for decision making (Kapil, 130). ii) Helpful in financial planning and forecasting Ratios are computed consistently from period to period. As a result, the ratios can be used to establish the future trends of the company’s performance thus helping to formulate future plans for the company. The analyses provide useful information for the firm’s future forecasting and planning (Khan, & Jain, 6.27).. iii) Comparison Financial ratios help in comparing companies and industries of different sizes with each other. Ratios show how well the company is performing over the years when compared to other companies in the same industry (Carlberg & Carlberg, 185). They create a standardized method upon which the comparison can be done because ratios put the firms on a somewhat equal playing field thus enabling the analyst to judge them on their performance instead of their market share, size or sales volume. In addition, they show how well the different divisions of the company are performing in different years. iv) Locating weaknesses Accounting ratios helps the company to locate weaknesses in its operations although its general performance may be quite good. v) Judging efficiency The accounting ratios such as profitability ratios help in determining the efficiency of the company in terms of its management and operations. They outline how well the firm has utilized its assets to earn profits (Carlberg & Carlberg, 181). vi) Helpful in co-ordination All companies have both weak points and strength points as may be shown in their financial results. Ratio analysis, therefore, helps in creating co-ordination between weak points and strength points. Limitations of ratio analysis Even though, financial ratio analysis is a very crucial tool in judging the performance of the company, it has several limitations. Some major demerits of financial ratio analysis include: i) Comparing two companies using ratio analysis might be very misleading in case the two companies operate in different industries. This is so because the companies experience different environmental conditions such as market structure, regulation and other factors (Bizfinance.). ii) Ratio analysis, usually, explains the relationships between historical or past information. However, users are normally concerned about future and current information. Ratios, therefore, fail to provide complete information for future planning and forecasting (Carlberg & Carlberg, 190). iii) Ratio analysis tends to give a false result in case they are computed from incorrect or false accounting data. In addition, they may be misleading if the accou8nting information is window-dressed. iv) Ratio analysis is tools of quantitative data thus ignoring qualitative point of view. Ratios fail to address issues like customer service, product quality, employee morale, management skills and so on (Bizfinance). v) Ratios are, usually, distorted by inflation. Inflation distorts financial statements, especially balance sheet. Any problem in the financials as a result of inflation is then passed on to ratios thus affecting their usefulness. vi) Ratios from different organizations are difficult to compare due to differences in accounting assumptions and ratio definitions. Accounting standards permit different accounting policies such as LIFO and FIFO inventory methods, thus impairing comparability rendering ratio analysis less helpful in such situations (Bizfinance.). vii) It is always very hard to draw inclusive conclusions about a company using the financial ratios alone. The ratio information cannot be clearly and systematically sifted into a single conclusion about the overall performance and health of the company (Kimmel et al 290). Conclusion Ratio analysis is a very vital tool of financial analysis. It helps in analyzing and interpreting financial statements thus determining the weaknesses and strengths, financial health and both historical and current performance. Despite such usefulness, ratios also have limitations that hinder their applicability. References Accounting Explained: Retrieved from:http://accountingexplained.com/financial/ratios/inventory-turnover Accounting tools.com: Retrieved from: http://www.accountingtools.com/inventory-turnover-ratio Bizfinance.about.com: Retrieved from:http://bizfinance.about.com/od/financialratios/tp/limitations-financial-ratio-analysis.htm Carlberg, C. G., & Carlberg, C. G. (2002). Business analysis with Microsoft Excel. Indianapolis, Ind, Que. Pg. 171 Dyson, J. R., Dyson, J., Dyson, J., & Dyson, J. (2007). Accounting for non-accounting students. Harlow, Financial Times Prentice Hall. Investopedia : Retrieved from: http://www.investopedia.com/university/ratios/ Kapil, S. (2011). Financial management. Noida, India, Pearson. Pg. 120-130  Khan, M. Y., & Jain, P. K. (2007). Financial management. New Delhi, Tata McGraw-Hill. Pg. 6.2-6.27 Kimmel, P. D., Weygandt, J. J., & Kieso, D. E. (2008). Accounting: tools for business decision making. Chichester, John Wiley. Pg. 290 MyaccountingCourse.com: Retrieved from:http://www.myaccountingcourse.com/financial-ratios/ Read More