The Usefulness and Limitations of Financial Ratios in Evaluating the Performance and Management of Companies - Essay Example

The Usefulness and Limitations of Financial Ratios in Evaluating the Performance and Management of Companies By of ] 1536 Words [Date] Introduction Constant monitoring and evaluation of performance is the key to business success. Through evaluation, a company can compare its performance with that if its competitors and confirm its growth by comparing its current performance with its historical figures (Williams et al., 2008). It can also compare itself with the figures of successful companies in the industry. A thorough evaluation of a company’s performance exceeds the mere examination and reporting of basic figures such as sales, profits and total assets; it requires the calculation of more intricate financial details for more comprehensible figures and ratios (Alexander, Britton & Jorissen, 2005). The effectiveness of financial ratios is evident in their use to simplify the massive data obtained and used in the financial analysis of performances (Wansleben, 2012). Financial ratios are well-tested performance measures by which a company identifies and quantifies its performance, weaknesses and strengths. Financial ratios help a company monitor and evaluate its financial position, thus promoting the understanding of company risks (Bodie, Alex & Alan, 2004). The financial ratios that a company can use to gauge its performance are income, profitability, liquidity, working capital, bankruptcy, long-term analysis, and coverage and leverage ratios (Weygandt, Kieso & Kell, 1996). This paper discusses the importance of financial ratios in evaluating a company’s performance, giving EasyJet’s 2013 financial ratios as examples. Usefulness of Financial Ratios Financial ratios are quite useful performance and profit tools in financial analysis (Wansleben, 2012). First, financial ratios are used by business financial analysts in the development and implementation of plans to improve profitability, liquidity, financial structure, reordering, leverage, and interest coverage. While in most cases financial ratios relate to past performance, they are also useful predictive tools, offering insights into the potential problems and solutions to challenges (Bradshaw, 2010). Financial ratios also indicate the trends in the performance of a company over a period. This type of financial ratio analysis is referred to as trend analysis, a process by which a company identifies its good and bad trends and adjusting them appropriately (Wansleben, 2012). Profitability Ratios Profitability ratios, closely linked to income ratios, are useful in showing a company’s effectiveness in the management concerning the returns on sales and investment. An example of profitability ratio is gross profit: net sales ratio, which indicates whether a company’s average mark-up on goods covers its expenses, implying a net profit (Houston & Brigham, 2009). If the gross profit rate is repeatedly lower than the average margin, the company is underperforming. Hence, its management should be wary of downward tendencies in its gross profit rate (Berezin, 2005). The other important profitability ratio for a company is the net operating profit ratios, which is a net profit on net sales ratio. It provides for a basic examination of a company’s net profit in relations to the resources invested (Houston & Brigham, 2009). The moment a company covers its key expenses, the increase in profit grows above sales and beyond the break-even point. Equally important profitability ratio is the net profit: tangible net worth ratio (Houston & Brigham, 2009). It is also used to appraise the net profits in relations to the investment, indicating the management’s capacity to earn returns on the investment. Liquidity Ratios Liquidity ratio is the other important financial ratio used in the examination of a company’s performance. This type of ratio is useful for purposes of working with short-term creditors, suppliers and bankers. In this context, financial managers use liquidity ratios to help them gauge and meet company obligations to suppliers, creditors and government agencies (International Accounting Standards Board, 2007). Through comprehensive liquidity ratio analysis, a company can identify and quantify its weaknesses regarding its financial position. An important liquidity ratio is the current ratio. It compares current assets and current liabilities. For EasyJet Plc, in 2013, the current ratio was 0.9 (EasyJet Plc, 2014). It has the benefit of indicating balance sheet changes not revealed by networking capital. The main purpose of current ratio is to reveal a company’s capacity to meet its current obligations. It is supplemented by myriad other liquidity ratios such as quick ratio, absolute liquidity ratio and receivable turnovers. The quick ratio indicates to the management whether a company’s current assets can be quickly converted into cash to cover its current liabilities (For EasyJet Plc in 2013, quick ratio 0.99) (EasyJet Plc, 2014). Additional sufficient quick assets indicate that a firm is in a good financial position. On the other hand, absolute liquidity ratio does not assume that all assets have equal liquidity; instead, it eliminates these uncertainties on receivables. For EasyJet Plc, in 2013, the total debt; total equity ratio was 0.29 while the total liabilities; total assets ratio was 1.05 (EasyJet Plc, 2014). Income Ratios The third type of financial ratios important in the evaluation of a company’s performance is income ratios. Once such ratio is turnover of total operating assets ratio, which is the ratio of net sales to the total operating assets. From this ratio, it is evident that an increase in sales would require an increase in the operating assets (Helfert, 2001). Similarly, insufficient sales volume would demand for a reduced investment. It is worth noting that this ratio is not a measure of profitability. Net sales: tangible net worth ratio is the other income ratio used to assess the performance of a company. The function of this ratio is to show whether a company’s investment is sufficiently proportional to its sales volume (Gomez-Mejia, David & Cardy, 2008). Through this ratio, a company can identify its likely credit or management problems (overtrading and under-trading). For example, if excessive sales are made on a small margin of investment, there is likely to be a problem with creditors. Although skilful management may translate into overtrading, creditors would still be required to give the company more finances (Weston, 1990). The other important income ratio is gross margin on net sales. The long-term analysis of this ratio informs a business of the necessity of examining its credit extension, purchasing and general merchandising policies. Working Capital Ratios The other important category of financial ratios is working capital ratios. The working capital ratios ensure that a company’s sales are built on effective and efficient current asset policies and enough gross and net working capital (Weston, 1990). While gross working capital refers to all current assets. Net working capital is the total current assets minus current liabilities. Inadequate current capital can be corrected by reducing sales or increasing current assets. The strategies for achieving these goals are internal savings and external savings. Internal saving could be done through retained earnings while external saving can be achieved by sale of stock (Weston, 1990). An example of this class of ratios is the working capital turnover, which compares net sales and net working capital. Through this ratio, a company can confirm if it has slow assets or top-heavy in fixed assets. Clearly, this ratio supports the net sales to tangible net worth ratio. Businesses also use bankruptcy ratios to evaluate their performances. These ratios give businesses warnings of impending bankruptcy before it is late. Bankruptcy ratio such as Cash Flow to Debt thus helps in the detection of financial problems. Under this category of financial ratios is the Working Capital to Total Assets, which compares the net working capital and total asset. This ratio reports on the net liquid assets to the total capitalization. It is perhaps the best indicator of impending financial disaster for a business. For instance, if a company records operating losses constantly, there is a likelihood of its current assets to shrink more than its total assets (Jan & Carcello, 2008). If this ratio has a negative reading, the implication is a negative net working capital and subsequent financial problems. The table below summarises EasyJet Plc’s financial ratios for 2013 (Morningstar.com, 2014) Fixed Assets Turnover 1.82 Asset turnover 0.98 Return on equity 20.89 Operating income 497 Operating cash flow 616 Working Capital 69 Receivables turnover 40.17 Financial leverage 2.19 Conclusion The main purpose of financial ratios in a company is to analyze its financial performance and growth, compared to its competitors and to assess its growth and stability over time. These ratios are used by companies across industries. Through these ratios, bankers, creditors, shareholders and accountants are best placed to assess and ascertain the performance of a company by evaluating the data presented therein. By analysing these ratios, a company’s creditors can make sound decisions on whether to continue or withdraw their funding. Similarly, shareholders can adjust their commitments depending on their analysis of these financial ratios. Through the discussed financial ratios, stakeholders in a company can adequately review the profitability, efficiency, liquidity and solvency of a company. Profitability ratios are important in the examination of the general effectiveness of the management of a company of sales, profit, operating margin and investment. On the other hand, efficiency ratios relate to the effectiveness of management in decision-making with reference to turnover, sales, receivables, return on assets and the return on investments. Liquidity ratios deal with a company’s ability to address its current obligations or the capacity of a business to convert its assets into cash and pay its creditors. Solvency ratios assess a company’s ability to raise capital and pay its creditors. 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