Importance of Financial Ratios for Firms Financial Results - Example

Table of Contents Particulars Page No 1.0 Introduction 2 2.0 Calculation of Ratios 3 3.0 Importance of Financial Ratios for Firms Financial Results 7 4.0 Importance of Financial Ratios for Comparing Financial Performance of Multiple Firms in the Same Industry 9 5.0 Conclusion 12 6.0 References 13 1.0 Introduction This report has been designed to equip readers with a clear understanding of the use of various financial ratios which has been calculated for Dr. John Consulting and Trading Company for the year ended 2016. The report then looks towards a more specific approach and highlights how financial ratios can be so important in understanding the health or otherwise, of a firm’s financial results. The report also looks to state the major reasons of the significance of financial ratios in comparing the financial performance of multiple firms operating the same or similar industry. Finally a conclusion is provided to ensure that the readers are gained with both theoretical and practical concept of the entire topic under study. 2.0 Calculation of Ratios The ratio’s for the year 2016 for Dr. John’s Consulting and Trading Company is calculated as under. Particulars Formula 2014 2015 2016 Current Ratio Current Ratio = Current Assets / Current Liabilities 1.12 0.97 (302/273)= 1.106 Quick Ratio Quick Ratio = Total Current Assets – Inventory - Prepaid expenses / Total Current Liabilities 0.70 0.56 (302-120)/273 = 0.67 Inventory Turnover Ratio Inventory Turnover Ratio = Cost of Goods sold / Average Inventory 9.52 9.39 (1160/120) = 9.67 Receivables Turnover Receivables Turnover = Net credit sales / Average Accounts Receivable 12.24 Days 7.60 Days (2900/90) =32.22 Times (360/32.22) =11.17 Days (Note 360 days has been considered for a year) Fixed Asset Turnover Fixed Asset Turnover = Net Revenue / Average Fixed Assets 16.89 17.88 (2900/156) = 18.59 Total Asset Turnover Ratio Total Asset Turnover Ratio = Net Sales / Average Total Assets 5.84 6.44 (2900/458) = 6.33 Debt Ratio Debt Ratio = Total Liabilities / Total Assets 0.68 0.75 (286/458) =0.62 Debt-to- Equity Debt –to – Equity = Total Liabilities / Total Equity 0.29 0.36 (13/172) =0.075 Times Interest Earned Times Interest Earned = Income Before Interest And Taxes / Interest Expenses 44.75 46.92 (1271/26) = 48.88 Gross Profit Margin Gross Profit Margin = Gross Profit / Net Sales*100 60% 60% (1740 / 2900)*100 = 60% Operating Profit Margin Operating Profit Margin = Operating Profit / Net Sales* 100 42.96% 43.44% (1271 / 2900)*100 = 43.83% Net Profit Margin Net Profit Margin = Net Profit / Net Sales * 100 30.45% 30.83% (903 / 2900) * 100 = 31.14% Return On Total Assets (ROA) Return On Total Assets (ROA) = Net Earnings / Total Assets * 100 177.86% 198.64% (903 / 458) * 100 = 197.2% Return On Equity (ROE) Return On Equity (ROE) = Net Income/ Share Holder’s Equity *100 547.66% 785.19% (903 / 172) * 100 =525% Earning Per Share Earning Per Share= Profit or Loss attributable to common equity share holders / Weighted Average Number of Shares Outstanding During the Year $ 1.45 $ 1.58 (857 / 500) $ 1.714 Price / Earnings Ratio Price / Earnings Ratio = Market Value Price Per Share/ Earnings Per Share 2.07 3.16 ( 5.50 / 1.174) 4.69 3.0 Importance of Financial Ratios For Firms Financial Results This section of the report looks to focus on the reasons of why financial ratios are of so important in the understanding of the health or otherwise of a firm’s financial results. Financial ratios are one of the most significant and most common tools used extensively in managerial decision makings. A ratio is virtually the use of mathematical formulas develop extensively with a purpose to both evaluate a firm’s performance and comparing it with other multiple firms in the same industry or making a trend analysis of its own performance over a period of time (Frase & Ormiston, 2004). It involves comparison of various figures from the prepared financial statements with a motive to obtain information about a firm’s performance. Financial ratios from decades have been one of the most useful tool in evaluating the performance and financial condition or health of a firm. One of the most significant contributions of financial ratios is the depiction of true picture of a firm in context to its strengths and weaknesses along with the survival position of the firm which helps in making probable accurate forecasting of the firms future growth and performance. Financial Ratios act as a significant tool in the hands of decision makers to take different operating decisions and make corrective actions for the betterment of the firm. Financial ratios not just compares the different figures or numbers from financial statements like the income statements, balance sheets or the cash flow statement but however compares the trends with previous years with other companies in the same industry or even against the economy in general. It not defines the relationship between individual values and relates such values with previous year’s data but helps in providing a diagnostic approach of the current performance of the firm and how it might perform in the future thereby acting as the most significant tool in the hands of both existing and potential investors (Weygandt, Kieso, & Terry 2001). Financial ratios helps in identification of trend analysis which is not just an useful tool in the hands of investors in making their investment decisions but also equally benefits the internal management system in forecasting future and accelerating the decision making process. It helps in assessing and evaluating the firms’ different operating fields such as profitability, liquidity, leverage etc which defines the true performance picture of the firm and enables the firm to reflect transparency in the preparation of its financial statements. Any deviation or reflection of the firm’s ratio’s from its previous findings or trend shown by the industry is an area of concern and makes the management accountable and responsible for such deviations to its investors as such deviations may negatively or positively impact the firm’s financial health. The financial ratios are further important for understanding of the health, or otherwise, of a firm’s financial results as financial ratios provides a clear basis for ensuring a dual comparison and evaluation of the firms performance on a two tier system as it provides both intra-firm comparison of the similar firms in the same or other industry as well as inter-firm comparison and evaluations, thereby ensuring no significant misguidance by the management in building their financial statements. Financial ratios are further the only variables which can be used in determination of bond ratings (Marshall, McManus & Viele, 2003). Analysis of the financial ratios of the current year with previous years or the standard ratios set earlier by the industry acts as a significant tool in the hands of management in performing their management duties in context to evaluation and controlling. Ratios thus, help to measure the relative performance of different financial measures which characterize the firm’s financial health as it provides a standardize measure which is easier to interpret and understand. It facilitates the accounting information to be summarized and simplified in a required form which is understood on global basis. Ratio analysis not just acts as a mere tool in finding a problem but eventually provides effective results in the removal and elimination of various types of wastages and inefficiencies. It helps the upper management for effectively and efficiently discharge their functions or duties such as planning, organizing, controlling, directing and forecasting thereby clearly affecting the health of the organization. Ratios further acts as an important communication tool for providing the most valuable information about financial soundness to various concerns such as proprietors, investors, creditors, government and other business related and associated parties. Thus, financial ratios provide assistance to the management to fix their responsibilities and determine the performance of the business in terms of various important indicators such as liquidity, profitability, solvency etc. Financial ratios provides the most easiest and most used guidance for all related parties associated with the firm’s business to whether continue or withdraw their business with an associated firm. Thus, it can be rightly said that understanding of financial ratios is one of the most important aspect to understand the financial results of any firm. 4.0 Importance of Financial Ratios for Comparing Financial Performance of Multiple Firms in The Same Industry Financial ratios unlike any financial tool, is the most important and most used financial tool for the purpose of not just evaluating the financial performance of a firm’s health or financial condition but is equally used as a comparison tool for finding deviations in different operating fields of a firm in the same industry. It helps in comparing the financial performance of multiple firms in the same industry as multiple firms in the same industry is most likely to perform in a similar trend and have little deviations in their financial performance (Provided the multiple firms are of same size and operate in the same market conditions). An industry basically comprises of more than one firm operating in the similar working and marketing conditions. Financial ratios usually act as the most common tool for the purpose of managerial decision making (Brigham, Eugene & Ehrhardt, 2005). One of the significant characteristic of financial ratios is to gain information and knowledge about a firm’s performance. It is more of an interpretation than calculation which makes financial ratios a useful tool for business managers (Zager, 2000). Ratios serve as indicators or standards to evaluate the firm’s creditability and performance in terms of profit generation, assets utilization, leverage position, liquidity status or market valuation. However, the usefulness of financial ratios is not limited or restricted to just evaluation or interpretation of a firm’s financial performance. Financial ratios in turn have dual advantage of firstly tracking the individual firm performance over time, by comparing its own ratios and trends of various years and finding reasons for any surprisingly deviations and secondly making a comparative judgement of the firm’s performance with other multiple firms in the same industry (Fridson, Martin, & Alvarez, 2002). One of the most significant usage of financial ratios apart from its usefulness as a measuring tool of the financial condition of any firm is to make relative performance comparison (Bhattacharya, 2007). For instance , financial ratios over the decade has been every effective and largely used in comparing a firm’s profitability or firm’s financial performance to that of a major competitor or analyzing and observing how a particular firm in a specific industry stacks up in comparison to the industry averages or standards. This comparison acts as a major tool for users to form judgements and decisions in matters of key areas such as profitability and management effectiveness. Users to such comparison comprises of both internal and external users. External users to such analysis mainly includes security analyst, existing and potential investors of the firm evaluated, list of creditors, small and big competitors and other industry observers. Internal users mainly comprises of managers who uses such financial ratios to monitor their own performance with the industry standards or multiple firms in the same industry and evaluate their strengths and weaknesses in order to build upon their specific goals, objectives and making necessary changes in their current policies and procedures to ensure better financial performance in future. Furthermore the comparative nature of financial ratios enables analyst to set industry standards which are then used as benchmark to compare not just individual firm’s financial performance but equally compare two firms within in the same industry and helps both the internal management and external users in management decisions and investment decisions respectively. Without the use of such financial ratios and comparing multiple firms on raw data basis shall actually hide the real transparency of financial statements and makes it very difficult for common investors in making a wise investment decision. For example, multiple firms in a specific industry might show a downfall in their profitability generation capacity on account of economic recession effect on such specific industry. Hence, looking at just the profit decline of multiple firms, an investor may make a wrong decision on basis of accurate or relative profit figures whereas the profit ratios may show true results. In simple sense, consider two firms A and B operating in the same specific industry with almost similar sizes and same working/marketing conditions. Suppose Firm A, has a sales $100 and generates profit of $25 whereas Firm B has a sales of $80 and makes a profit of $22. Comparatively on analyzing the two firms in same industry Firm A looks better off with higher profits however, in reality it is Firm B which is better off as the Net profit margin of Firm A is just 25% as compared to Firm B which enjoys a higher profitability of 40%. Hence, such comparison can only be possible by help of calculations of ratios which makes it simpler and transparent for users to understand the real growth of business. The comparative nature of financial ratios in comparing the financial results of multiple firms in a specific or similar industry is not just beneficial or important for investors but equally important for internal management in framing their market policies and strategies (Thachappilly, 2009). Financial ratios help management to figure out the real reasons for their deviations of results with other firms in the same industry and develop strategies to achieve the industry standards (Clausen, 2009). Thus, it can be rightly said that financial ratios are of the most key ingredients in one’s ability to compare the financial performance of multiple firms operating in a specific or same industry. 5.0 Conclusion The report provides complete analysis of ratios and show calculations of various ratios for Dr John Consulting and Trading Company and then enumerates the specific advantage of financial ratios in understanding the firm’s financial results and its comparative nature for trend analysis and comparison of multiple firms in same industry. 6.0 References Bhattacharya, Asish. K. (2007). “Introduction to Financial Statement Analysis”, Elsevier, New Delhi , 1st edition, Chapter -03 , Ratio Analysis, pp.32-45 Brigham, Eugene F., and Micheal C. Ehrhardt, eds. (2005). Financial Management: Theory and Practice. Ohio: South-Western. Clausen, James. (2009). “Accounting 101 – Financial Statement Analysis in Accounting: Liquidity Ratio Analysis Balance Sheet Assets and Liabilities”, Journal of financial statement. Frase, L., & Ormiston, A. (2004). Understanding Financial Statements. New Jersey: Pearson Prentice Hall. Fridson, Martin, and Fernando Alvarez. (2002). Financial Statement Analysis: A Practitioner's Guide. New York: John Wiley. K. Zager. (2000). “Accounting Information in the Function of Business Quality Measuring”, 23 rd Annual Congress of the European Accounting Association, Muenchen. Marshall, D., McManus, W., Viele, D. (2003).Managerial Accounting and Cost-Volume-Profit Relationships. Accounting: What the numbers mean (6thed.). New York: Ross, Stephen A., Randolph W. Westerfield, and Jeffrey Jaffe, eds. (2008). Corporate Finance. Boston: McGraw-Hill/Irwin press. Thachappilly, Gopinathan. (2009). “Debt Ratios Look at Financial Viability/Leverage: The Ratio of Debt to Equity Has Implications for Return on Equity”. Journal of debt ratios analysis. Weygandt, J. J, Kieso, D. E., & D, Warfield Terry (2001). “Intermediate Accounting: Earning per share”. (10thed.). Bearcat Company, Vol-1.p. 831. Read More