Financial Ratios Importance - Example

Running header: Financial ratios Income Tax Law Author’s Name Institutional Affiliation Date of submission 1. 2016 Financial Ratio Calculations Ratio Formula Calculation Current ratio = total Current assets/total Current liabilities =$302/273 = 1.11 Quick ratio =(Total current assets-Inventory)/Current liabilities = ($302-120)/273 = 0.67 Inventory turnover =Cost of goods sold/ average inventory Average inventory =($115+120)/2= $117.5 Inventory turnover =$1,160/117.5 = 9.87 Accounts receivable turnover days =(average accounts receivable/Net credit sales)*365 Average accounts receivable =($57+90)/2 =$73.5 Accounts receivable turnover (days) =( 73.5/2,900)*365 = 9.25 days Fixed asset turnover =Net sales/ average fixed assets Average fixed assets = ($151+156)/2 =$153.5 Fixed asset turnover =$2,900/153.5 = 18.89 Total asset turnover =Net assets/ Average total assets Average total assets =($419+458)/2= $438.5 Total assets turnover = $2,900/438.5 =6.61 Debt ratio =Total liabilities/Total assets =$286/458 = 0.62 Debt-to-Equity =Total liabilities /Shareholders equity =$286/172 = 1.66 Times interest earned =EBIT/Interest expense = $1,271/26 =48.88 Gross profit margin =Gross profit/ Sales revenue = $1,740/2,900 =60% Operating profit margin =Operating profit /Net sales =$1,271/2,900 =43.83% Net profit margin = Net profit/net sales =$903/2,900 =31.14% Return on total assets =Net income/ Total assets =$903/458 = 197.16% Return on equity =Net income/ Shareholders equity = $903/172 = 525% Earnings per share =Net income/Average outstanding shares =$903/500 = $1.806 Price/Earnings ratio =Market value per share/Earnings per share =$5.50/1.806 = 3.05 2. Why financial ratios are so important to our understanding of health or otherwise of a firm’s financial results Introduction In assessing the health or otherwise of a firm’s financial results, the management as well as other organizational stakeholders look at a number of factors. Some of these factors include the firm’s ability to pay its debts as and when they become due. Another important aspect of a firm’s financial health is its liquidity or the degree to which the firm has working capital and hence its ability to meet its maturing debt obligations. A firm’s financial health is also measured by the firm’s profitability from its assets, the amount of debt that the firm is using to finance its assets Vis a Vis shareholders equity as well as the rate of returns that its owners earn from their equity investment in the firm among other factors (Adedeji, 2014). In a bid to assess all these factors that have implications on the firm’s financial health, the management as well as other stakeholders use a number of tools. One of the most important tools used by firms in assessing and hence understanding their health or otherwise of their financial results is financial ratio analysis. This tool uses mathematical comparisons of financial statement accounts and is useful in helping various stakeholders in understanding how well their firms are performing and where the firms need to improve on. This section discusses why financial ratios are so important to our understanding of health or otherwise of a firm’s financial results. In a bid to rightly assess a firm’s financial health, firms constantly assess their performance by comparing their present performance with their historical figures, with their competitors as well as with other successful businesses in their industries of operation. However, it is worth noting that getting a thorough examination of a firm’s financial health, one needs to look at more than just raw numbers like sales figures, total assets and profits. One needs to go beyond raw numbers and read between the lines of the firm’s financial statements thus making the numbers that seem inconsequential accessible and comprehensible. This is because it is very difficult for one to infer into the firm’s financial health by just comparing two simple numbers (Kuvek, 2013). Thus, financial ratio analysis is seen as an effective tool for providing information about the health or otherwise of the firm’s financial statements. It is worth noting that the interpretation as opposed to calculation of financial ratios makes financial ratios an important tool for gauging a firm’s financial health. The interpretation will give indications, red flags or clues regarding the relationship of the various variables that measure a firm’s financial health as far as its profitability, liquidity, asset utilization, market valuation or leverage is concerned. Therefore, by comparing carefully a combination of the various financial ratios available, one is able to gauge the firm’s financial health and hence able to distinguish whether the firm may fall in future or become stronger in future. Financial ratios analysis helps analyze the firm’s financial health in two ways. First, if the ratios computed are too low, then this would signal cause for concern about the firm’s financial health. However, when the ratios are high, then one would conclude that the firm’s financial health is good. Another way in which the financial ratio analysis helps in understanding the firm’s financial health is through tracking the firm’s performance over time and hence making comparative judgements regarding how the firm has been performing. In this case, trend analysis is used in evaluating the firm’s financial performance and hence its financial health by calculating the various ratios on a per period basis and tracking these values over a certain period of time (Referenceforbusiness.com, 2016). For instance I the ratios calculated above are for three years. A look at them can reveal whether the firm’s financial health is improving or deteriorating depending on whether they have improved from 2014 to 2016. One can also be able to spot trends which may be reason for concern for the firm’s financial health. For instance, if the firm’s average outstanding receivables collection period has been increasing, or its liquidity status has been declining, then this can be a cause for concern for the firm regarding its financial health. In this way, financial ratios are regarded as red flags for areas of concern or as performance measurement benchmarks. It is in this regard that financial ratios are regarded as an important tool in judging the health or otherwise of a firm’s financial results. One of the reasons why financial ratio analysis is considered important in understanding the health or otherwise of a firm’s financial results is its ability to gauge the firm’s profitability. A firm’s profitability is considered as an important indicator of a firm’s financial health as a firm that is always making losses will not survive in the market and hence its financial health is not considered good. Financial ratios analysis uses various ratios including return on assets, various profit margins and return on equity which are computed to enable one draw conclusions on whether the firm is profitable enough as well as whether it is giving adequate return to the investors. This would also point to the firm’s ability to meet its obligations to various stakeholders. By comparing the profitability ratios over time, one is able to tell whether the firm’s profitability is declining or improving (Vitez, 2016). An improving profitability will indicate good financial health while a declining one would indicate bad financial health for the firm. It is also worth noting that one cannot be able to gauge the firm’s leverage by just comparing raw numbers. Financial ratio analysis thus is important in helping gauge the firm’s leverage which is an important aspect of the firm’s financial health. A firm’s leverage is evaluated using ratios such as debt ratios. The leverage ratios are important in gauging the health of a firm’s financial results since it tells the firm whether it has accumulated a lot of debt that its ability to repay the principal and the interest would be limited or otherwise. A high debt ratio would be a cause for worry as far as the firm’s financial health is concerned since inability to repay interest and principal would increase the threat of takeover or even hamper operations which would bring the company down. On the other hand, a low debt ratio would help the firm decide whether there is still room for more debt to carry out profitable projects in future. In this regard therefore, financial ratios analysis is deemed an important tool in gauging the health or otherwise of a firm’s financial results by helping the firm decide whether its leverage levels are acceptable or not. Financial ratio analysis is also deemed important in understanding the health or otherwise of a firm’s financial reports since it helps in measuring the firm’s liquidity. The firm’s liquidity is an important aspect of its financial health as it determines the firm’s ability to go on with its day to day operations and hence its survival. This is because a firm’s operations will be hampered if it has no liquidity to meet its day to day financial obligations. A firm’s liquidity is evaluated through financial ratios analysis by calculating the firm’s current and quick ratios. In most cases, a firm’s quick ratio is deemed a better standard of evaluating a firm’s liquidity. When it is greater than one, the firm is deemed to have no danger of not being able to meet its current financial obligations. However, if the ratio is less than one but with current ratio being considerably above one, then the status of the firm becomes more complex and the valuation of its inventory and its inventory turnover is deemed critical. A trend analysis of the above liquidity ratios for a firm could also point to its financial health. If the ratios have been declining over the years, then this indicates that the firm’s financial health is at stake and hence the management needs to take remedial measures to avert a situation where the firm’s day to day operations would have to be halted. This would ensure its continued financial health (Florenz, 2012). Another reason why financial ratio analysis is deemed important in understanding the status of a firm’s financial health is because it is a good way of gauging a firm’s operational efficiency. A firm’s operational efficiency is an important aspect of its financial health since it determines the firm’s ability to continue operating profitably. In this regard, financial ratio analysis helps a firm understand such issues as whether its receivables are being collected on time, whether its inventories are being turned over effectively and whether the company is operating efficiently (Bajkowski, 2016). This is done through measuring such ratios as inventory and receivables turnover days. If such ratios are noted to be declining, then there is a concern for the firm’s financial health and the management needs to implement remedial measures to ensure that the firm is operating efficiently. By helping the firm know whether it is operating efficiently and hence take necessary measures, financial ratios analysis in no doubt acts as a good determinant of the health or otherwise of the firm’s financial results. Conclusion As discussed above, financial ratio analysis is an important tool in helping firm’s determine the health or otherwise of their financial results since it analyses the results not from raw numbers but from ratios that are better indicators of the firm’s financial health. In this regard, financial ratios analysis helps in determining important aspects of its financial health including profitability, liquidity, operational efficiency and leverage among others thus helping the firm make informed decisions aimed at ensuring the firm’s good financial health. By comparing ratios from different financial periods, trends emerge that help in deciding whether the firm’s financial health is good or not. This is why financial ratios analysis is such an important tool in understanding the health or otherwise of a firm’s financial results. 3. Why financial ratios are important in our ability to compare the financial performance of multiple firms in the same industry Apart from measuring individual firm’s performance, financial ratios are also important in our ability to compare the financial performance of multiple firms in the same industry. For instance, we can compare a firm’s profitability with that of its major competitor. We can also compare how a firm is performing when compared with other firms in the industry. By comparing the firm with industry averages, the financial statement’s user is able to make informed judgements that concern key areas of the firm’s performance including profitability as well as the management effectiveness (Abdel-Rahman, 2013). This way, a firm is able to gauge itself with other firms and the industry trends as well and hence know whether it is performing well or there is need for improvement in performance. By using financial ratios, the firm is also able to know its weaknesses and strengths by comparing its financial performance with other firms in the industry and hence the management is able to make decisions that make the company stronger in comparison to its competitors and other industry players. Financial ratios are also deemed important in comparing financial performance of multiple firms in the same industry because they avoid using raw numbers to compare different companies which might differ in size and hence which might have different levels of performance. Thus, financial ratios are seen as a standard way of comparing the different firms in an industry. Financial ratios help us compare different firm’s financial performance although they might be of different sizes. In other words, financial ratio analysis would help us compare a company as big as Google with a small search engine company operating in a single country despite the fact that Google’s sales might be in terms of billions while the small company might have its sales in thousands (Jared, 2012). This would not be possible if raw numbers were to be used since this would obviously show the smaller company’s results to be worse off when compared to those of Google while this might not be the case in reality. Thus, financial ratios are deemed important in comparing different firm’s financial performance as they give a more accurate picture of how the different companies perform. Using raw numbers, a bigger company might always be presented as performing better as far as profitability, efficiency, liquidity, and leverage is concerned while this might not be the case. However, financial ratio analysis provides a standard comparison tool despite the differences in sizes. Another important reason why financial ratios are deemed important in comparing the financial performance of different firms is because they reveal the true picture or the trend of how the industry is operating. This would help the firm’s management to establish the minimum performance standards that the firm should achieve (Ivy, 2015). In this regard, a company like Google might benchmark itself against a small local company as far as financial performance is concerned for instance by setting the profit margin that the smaller company has already achieved as its performance target. Thus, financial ratios are deemed important in comparing financial performance of different firms by bringing to the same comparison level or platform despite their different size and location thus enabling the management to accurately compare themselves with industry standards. References: Adedeji, E2014, A tool for measuring organization performance using ratio analysis, Research journal of Finance and Accounting, vol. 5, no. 19, pp. 16-24. Kuvek, P2013, The relative importance of financial ratios and nonfinancial variables in predicting of insolvency, Croatian Operational Research Review, vol. 4, pp. 187-197. Referenceforbusiness.com, 2016, Financial ratios, Retrieved on 25th August 2016, from; http://www.referenceforbusiness.com/management/Ex-Gov/Financial-Ratios.html Vitez, O2016, Three important financial ratios for competitors, Retrieved on 25th August 2016, from; http://smallbusiness.chron.com/three-important-financial-ratios-competitors-3976.html Florenz, T2012, A comparative analysis of the financial ratios of listed firms belonging to the education subsector in the Philippines for the year 2009-2011, International Journal of Business and Social Sciences, vol. 3, no. 21, pp. 1-18. Bajkowski, J2016, Financial ratio analysis: Putting the numbers to work, Retrieved on 25th August 2016, from; https://www.aaii.com/journal/article/financial-ratio-analysis-putting-the-numbers-to-work Abdel-Rahman, K2013, The role of financial ratio in evaluating performance, Interdisciplinary Journal of Contemporary Research in Business, vol. 5, no. 2, pp.13- 29. Jared, B2012, Financial accounting, London, Rutledge. Ivy, K2015, Advanced financial accounting, New York, Taylor & Francis. Read More