Introduction
A ratio is an expression of the relationship between two or more variables. It expresses a mathematical relation between two or more items. In financial accounting, these are items found in the balance sheet and profit and loss account. Ratios are widely used tools of interpretation of financial statements. They provide clues to the changes in the financial statements. Ratio analysis as such is not an end in itself; rather they identify areas, which require further investigation. Ratio analysis involves computing and interpreting the relationship between the relevant financial items. This paper provides a detailed description and analysis of the topic of ratio analysis.
Basic Concept
Financial ratio analysis is the calculation and comparison of ratios, which are derived from the information in an enterprise’s financial statements. Financial ratios are calculated from different pieces of information from an enterprise’s financial statements. The trends of these ratios are used to make inferences about an enterprise’s financial condition, its operations, and attractiveness as an investment. Ratio analysis is not just comparing figures from the financial statements. It involves comparing the figures against previous years, other enterprises in the industry, or the economy in general (Halkos & Tzeremes, 2012, p. 5874). Ratios analyze the relationships between individual values and relate them to how an enterprise has performed in the past, and might perform in the future.
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In isolation, a financial ratio is a useless piece of information. It is of little use to analysts unless there is a good basis for comparison. A ratio gains utility by comparison to other data and standards. For instance, a gross profit margin for an enterprise of twenty-five percent is meaningless by itself. If we know that this enterprise’s competitors have profit margins of ten percent, we know that it is more profitable than its industry. If we also know that the trend is upwards, this would also be a favorable sign that management is implementing effective business policies and strategies. In context, however, a ratio can give an analyst a good picture of an enterprise’s financial situation and the trends that are developing over time (Hill, Perry & Andes, 2011. P. 66). The following are used as a basis for such comparison. The comparison may be both inter-enterprise as well as intra-enterprise comparison. The inter-enterprise comparison involves comparison with the best enterprise in the industry and the average enterprise in the industry.
The inter-enterprise comparison has the benefit of identifying how well the enterprise is performing compared with similar enterprises; however, it may be difficult to compare if the enterprises use different accounting policies. The intra-enterprise comparison involves comparison of the enterprise ratio with either past or budgeted ratio (Delen, Kuzey & Uyar, 2013, p. 3973). Ratios may be presented in three different forms namely, pure ratio, percentage, or sometimes. The pure ratio is a ratio of form X: Y; say a ratio of current assets to current liabilities is 3:2. It is the form commonly used in mathematics to imply a ratio of relationship. The percentage is the most commonly used form of a ratio where a variable is expressed as a percentage of another. The number of times is a ratio in which a variable is expressed as sometimes of another, for instance, credit sales are for time debtors.
The form of ratio to use depends largely on the audience to which it is presented and the variables in question. For instance, percentage form is used where the target is the public who may not have adequate mathematics and accounting background. Uses of ratio analysis include.
Evaluating the performance of an enterprise by comparing its performance with that of previous years that of competitors and the industry in general.
Setting benchmarks for performance through budgeted ratios.
To highlight areas that needs improvement as well as those with the most potential.
To enable external parties such as lenders and investors to assess the creditworthiness and profitability of an enterprise.
Financial ratio analysis groups ratios into categories, which reveal the different aspects of an enterprise’s finances and operations (Halkos & Tzeremes, 2012, p. 5876). An overview of the functional categories of ratios is as follows:
Profitability ratios
These ratios express the results of activities about the resources employed. They are a good indicator of the management efficiency in utilizing the resources at their disposal. This family of ratio targets all users of accounting information, and thus, it is best expressed in percentage form. The ratios under this category include gross profit margin, gross profit markup, net profit margin, return on capital employed, return on shareholder’s equity, and return on assets.
Liquidity ratios
This is a group of ratios that help in analyzing the ability of an enterprise to meet the short-term obligations. They show the relationship between the current assets and current liabilities. The relationship shows the ability of the current assets to meet the current liabilities, and it shows the mode of financing the current assets. The ratio is normally expressed in pure form. The ratios under this category include acid-test ratio and current ratio.
Turnover/activity ratios
These ratios measure the efficiency of utilization of resources at an enterprise’s disposal. Activity simply refers to the utilization of resources whereas the extent is best described regarding sales. Activity ratios often target those involved in managing an enterprise or those assessing the efficiency of management. The ratios are mostly presented in the number of times form. The ratios under this category include turnover periods and collection periods.
Gearing ratios
These ratios measure the long-term solvency of an enterprise. The long-term solvency is the ability to meet the long-term obligations of an enterprise. In financial analysis, external capital is seen as a lever used to provide the enterprise’s finances with extra force. Gearing refers to the extent to which an enterprise is financed through borrowed capital.
Investment ratios
These ratios measure both profitability and return on the shareholders’ investment as well as the business dividend payout policy. An enterprise, as a matter of policy, pays out a good proportion of its profits in terms of dividends hence the ratios can also be referred to as dividend ratios. The ratios include earnings per share, dividend per share, dividend payout ratio, and retention ratio.
Limitations
There are some limitations posed by ratio analysis such as the fact that all the information used in is derived from historical results. This problem is evident because using historical information does not imply that the same results will be carried forward. There is also considerable subjectivity involved in interpreting ratio analysis elements because there is no ideal yardstick for the many ratios (Delen, Kuzey & Uyar, 2013, p. 3981). Also, it is hard to reach a definite conclusion when some of the ratios in a family are favorable, and others are not. Sometimes, ratios may not be comparable for different enterprises due to factors such as different accounting periods and practices. Furthermore, if an enterprise is engaged in diverse product lines, it may be difficult to identify the industry category to which the enterprise belongs. Also, just because a specific ratio is better than the average number does not necessarily imply that the enterprise is doing well. It is also quite possible that the rest of the industry is performing poorly.
Ratios are also based on financial statements that are historical in nature. Hence, unless they are stable, it becomes difficult to establish reasonable projections about future trends. Moreover, financial statements such as balance sheets indicate a snapshot picture and may not be representative of longer periods.Financial statements do not always include each item. The only items present are those in which monetary values can be imputed. For instance, it is difficult to put a value on human capital such as management expertise. Accounting standards and practices also vary depending on a country’s policies hence global comparisons are greatly hampered. Ratio analysis does have several problems that limit its usefulness. However, as long as one is aware of the challenges, ratio analysis can turn out to be useful if the right supplemental methods are used to collect and interpret information.
Ratio analysis may possess a number of challenges especially with interpretation but nevertheless, it has been used by companies as a tool to expand and increase sales. Theoretically, the concept is a bit difficult to understand, but when applied, it works much easier than expected.
References
Delen, D., Kuzey, C., & Uyar, A. (2013).Measuring firm performance using financial ratios: A decision tree approach. Expert Systems with Applications , 40 (10), 3970-3983.
Halkos, G. E., & Tzeremes, N. G. (2012).Industry performance evaluation with the use of financial ratios: An application of bootstrapped DEA. Expert Systems with Applications , 39 (5), 5872-5880.
Hill, N. T., Perry, S. E., & Andes, S. (2011). Evaluating firms in financial distress: An event history analysis. Journal of Applied Business Research (JABR) , 12 (3), 60-71.
