Financial ratios and their implications along with their usage - Literature review Example

?Literature review Introduction The second chapter of the research study presents important theoretical concepts that would be used to answer the research questions of the study. In the literature review, important financial ratios and their implications along with their usage have been explained. Different types of financial ratios have been discussed in this chapter and all these financial ratios will be calculated for the three firms under study; Tesco, ASDA and Sommerfield in the research study. Financial ratios Financial ratios have been used by firms around the world to analyse how one firm performs in comparison to the other firm as well as to analyse the performance of the firm over the period of years. Therefore management calculates and uses financial ratios to identify the performance gap of the firm against its own past performances as well as against the performance of competing firms in the industry (Johnson, & Scholes 2001). In addition to this, management uses to analyse the financial performance of the firm against the average financial ratios of the firms operating in the industry as well and then identify areas where the firm has not been performing up to the mark. Some organisations use the financial ratios for the purpose of benchmarking as well and they tend to set different targets for different kinds of financial ratios and then make efforts to achieve these financial ratios (Brinckerhoff, 2000). For instance, a firm would like to achieve a profit margin of 20% and therefore in order to achieve this profit margin, the company would be making efforts to reduce the cost of the company or generate more sales so that costs is allocated to more sold units and targeted profit margin is achieved. Financial ratios are an important indicator about the performance of the firm and therefore it has been used not only by the management of the organisation but these financial ratios have also been used by investors, shareholders, suppliers, distributors and other stakeholders to analyse the financial performance of the company. Shareholders and investors use financial ratios to analyse whether they should invest in the firm or not. Suppliers and distributors analyse financial ratios to calculate whether the firm would be able to meet their obligations. Financial ratios can be subdivided into five major types of financial ratios on the basis of what these ratios reflect: 1. Profitability Ratios 2. Liquidity Ratios 3. Activity Ratios or Efficiency Ratios 4. Leverage Ratios 5. Market Ratios There are different financial ratios included in each of the five categories discussed above and each type or of ratios have their own importance and implications. TYPES OF FINANCIAL ratios Profitability Ratios Profitability ratios reflect how the firm is making profits using the assets or resources it has (Kaplan, and Atkinson, 1998). There are different types of profitability ratios and some of the most important profitability ratios have been discussed below: Profit Margin Profit margin of the firm is calculated using two variables; net profit of the company and the net revenue or net sales. Profit margin reflects the percentage of profits the firm earns out of the total revenue it generates. Formula for calculating profit margin is as follows: Higher profit margin of the firm shows that the cost of making profits is low and lower profit margin indicates that the cost of the company is high. Negative value of profit margin indicates a loss. Gross Profit Margin Gross margin of the firm reflects the profits generated by the company after deducting the production cost (Khan, 1993,). Higher gross profit margin reflects that the cost of production of the firm is low and vice versa. The formula for calculating gross margin is as follows: Operating Margin or Operating Profit Margin Operating profit margin of the firm reflects the ratio of operating profits of the firm against the net sales (Atkinson, Kaplan, Matsumura, & Young, 2007). Operating profit margin can be calculated using the following ratio: Operating profit margin basically reflects the profit generated by the firm from its operations. Return on Investment Return on investment shows the percentage of profits that the firm generates on its total investment. Because investors and shareholders are looking to make the most of their investment and therefore a firm that earns higher returns with lower investment would be preferable because it would show that the firm is able to make use of its funds in the most appropriate way and it generates the profits with the least investment (Arnold, 2008). Formula for calculating return on investment is below; Investors would prefer investment opportunities or firms that generate higher return on investment, considering the risk of all the investment opportunities or firms is the same (Alexander, and Sheedy, 2005). Return on Assets Return on assets shows that the extent to which a firm makes use of its assets in the most productive way (Kumar, & Sharma, 2005). The higher return on assets shows that the firm is able to generate higher returns on its total assets. Formula for calculating return on assets is below: Return on Equity As the firm belongs to the shareholders and the investment they make is recorded in the equity section of the balance sheet, therefore shareholders and investors analyse the financial performance of the firm by calculating the net profit generated on the total equity of the firm. Liquidity Ratios Liquidity ratios of the firm reflect the liquidity position and show the competency of the firm to pay off its debt (McNeil, Frey, & Embrechts, 2005). Some of the most important liquidity ratios are as follows: Working Capital Working capital of the firm shows the amount of cash the firm has after paying off its current liabilities. Higher working capital shows that the firm has more cash on hand if its current liabilities are paid off. Current Ratio Current ratio of the firm reflects the ability of the firm to pay off its current liabilities. Higher value of current ratio reflects that the firm is in a strong position to pay off its debt whereas if the value of current ratio is less than 1 then it shows that the firm does not have enough current assets to pay off its current liabilities. Asset Test Ratio or Quick Ratio Quick ratio shows the ability of the firm to pay off its current liabilities from its current assets excluding inventories. The idea behind using quick ratio is that some of the current assets like inventory are not easily convertible into cash and therefore assets other than inventory are used to calculate quick ratio (Borodzicz, 2005). Formula for calculating quick ratio is: Cash Ratio Some firms use cash ratio instead of current ratio or quick ratio. Cash ratio shows the ability of the firm to pay off its current liabilities with the cash or marketable securities the firm has on hand (McLaney, 2009). The formula for calculating cash ratio is as follows: Activity Ratios or Efficiency Ratios Efficiency ratios of the firm show the ability of the firm to make better use of its resources. In other words, it basically shows the efficiency of the firm. Higher the value of efficiency ratios, the more productive the firm is. Fixed Assets Turnover Fixed assets turnover shows how efficient the firm is in utilising its fixed assets in order to generate revenues. The formula to calculate the fixed assets turnover is below: Total Assets Turnover Total assets turnover shows how efficient the firm is in making use of its total assets and in generating revenues (Gitman, 2003). Total assets turnover is calculated using the following formula; Leverage Ratios Leverage ratios of the firm show the capability of the firm to pay off its long term debt (Glueck , 1980). Some of the most important types of leverage ratios have been discussed below: Debt Ratio Debt ratio represents the percentage of total liabilities in the total assets of the firm (Leland, 2002). Higher liabilities indicate more risk of the company, however certain amount of liabilities should be present in the capital structure of the firm in order to maximise the return on investment (Froot, Scharfstein, & Stein, 1993). Debt to equity ratio Debt to equity ratio is the ratio showing the relationship between total liabilities of the firm and the equity. Debt to equity ratio of value ‘1.0’ shows that the total liabilities are the same as the total equities in the capital structure of the firm (Friedlob, & Plewa, 1996). Formula of debt to equity ratio is as follows: Interest Coverage Ratio Interest coverage ratio is used by management as well as investors to analyse the ability of the firm to pay off its debt obligations. This ratio also answers the question of investors whether the profits generated are sufficient enough to pay the finance cost or interest cost. Market Ratios Market ratios are used to measure the financial return that the shareholders or investors of the firm earn. Some of the most important financial ratios in the market ratios category are discussed below: Earnings per share Earnings per share is one of the most important financial ratios used by shareholders to identify and analyse the return that shareholders would be earning by investing in the shares of the company. Earnings per share of the company show the earning per share that the shareholder earns as they invest in the stock of the company and it is calculated using the following formula: Firms are able to attract more investors with higher earnings per share, if the risk of the other firms is considered to be equal. Dividends per share Dividends per share indicate the amount of dividend an investor receives after buying the shares of the company (Ross, Westerfield, and Jordan, 2009). Formula for calculating dividend per share is as follows: Payout Ratio Payout ratio shows the ratio of earnings the firm has paid in the form of dividends to its shareholders. Some shareholders would like to get high current income as they are looking for higher payout ratio from the company and for this reason they generally invest in companies having higher payout ratio. Dividend Yield Dividend yield is the ratio between the dividends per share and the price of the share. Dividend Cover Dividend cover shows how much the ratio between the dividends per share paid to the shareholders against the total earnings per share. It is calculated using the following formula Price to Earnings Ratio Price to earnings ratio reflects the price paid by the shareholders of the company for a share to the earnings of the company per share (Jaffe, 2007). Summary Literature review section of the research study covered the financial ratios that firms, shareholders, investors, suppliers, distributors, competitors and other stakeholders including government agencies use to analyse the performance of the firm. The financial ratios are not only used to analyse the performance of the firm against its past performance or the performance of the competing firms operating in the industry, but these financial ratios are an important source to analyse where the firm is going from the current position. 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