MARKET TRIVIA

Understanding financial ratios

Financial ratios are tools for interpreting financial statements to provide a basis for valuing securities and appraising financial and management performance. When it comes to investing, analysing financial statement information is one of, if not the most important element in the fundamental analysis process. At the same time, the massive amount of numbers in a company’s financial statements can be confusing and intimidating to many investors. However, through financial ratio analysis, you will be able to work with these numbers in an organised fashion.

The objective of this article is to provide you with a guide to sources of financial statement data, to highlight and define the most relevant ratios, to show you how to compute them and to explain their meaning as investors.

The ratio analysis and industry analysis tools below are very useful for individuals to instantly assess a company or industry by making two basic types of comparisons. First, the analyst can compare a present ratio with past (or expected) ratios for the organisation to determine if there has been an improvement or deterioration or no change over time.

Second, the ratios of one organisation may be compared with similar organisations or with industry averages at the same point in time. This is a type of “benchmarking” so that one may determine whether the organisation is “average” in performance or doing better or worse than others.

For the professional, conducting such in-depth analyses is critical, allowing an analyst to make an informed business or investment decision.

In assessing the significance of various financial data, experts engage in financial analysis, the process of determining and evaluating financial ratios.

A ratio is a relationship that indicates something about a company’s activities, such as the ratio between the company’s current assets and current liabilities or between its accounts receivable and its annual sales.

The basic source for these ratios is the company’s financial statements that contain figures on assets, liabilities, profits, and losses. Ratios are only meaningful when compared with other financial information.

Since they are most often compared with industry data, ratios help an individual understand a company’s performance relative to that of competitors and are often used to trace performance over time.

Financial analysis can reveal much about a company and its operations. However, there are several points to keep in mind about ratios. First, a ratio is a “flag” indicating areas of strength or weakness.

One or even several ratios might be misleading, but when combined with other knowledge of a company’s management and economic circumstances, financial analysis can tell much about a corporation. Second, there is no single correct value for a ratio.

The observation that the value of a particular ratio is too high, too low, or just right depends on the perspective of the analyst and on the company’s competitive strategy. Third, financial ratios are meaningful only when compared with some standard, such as an industry trend, ratio trend, a trend for the specific company being analysed, or a stated management objective.

In trend analysis, financial ratios are compared over time, typically years. Year-to-year comparisons can highlight trends and point up the need for action. Trend analysis works best with five or more years of ratios.

The second type of ratio analysis, cross-sectional analysis, compares the ratios of two or more companies in similar lines of business. Cross-sectional analysis: comparing a company’s financial ratios to the industry in which the company competes is one of the most popular and highly recommended method.

Purposes and considerations of ratios and ratio analysis

Ratios are highly important profit tools in financial analysis that help financial analysts implement plans that improve profitability, liquidity, asset management, leverage, and valuation. Although ratios report mostly on past performances, they can be predictive too, and provide lead indications of potential problem areas.

Ratio analysis is primarily used to compare a company’s financial figures over a period of time, a method sometimes called trend analysis. Through trend analysis, you can identify trends, good and bad, and adjust your business practices accordingly. You can also see how your ratios stack up against other businesses, both in and out of your industry.

There are several considerations you must be aware of when comparing ratios from one financial period to another or when comparing the financial ratios of two or more companies.

If you are making a comparative analysis of a company’s financial statements over a certain period of time, make an appropriate allowance for any changes in accounting policies that occurred during the same time span.

When comparing your business with others in your industry, allow for any material differences in accounting policies between your company and industry norms.

When comparing ratios from various fiscal periods or companies, inquire about the types of accounting policies used. Different accounting methods can result in a wide variety of reported figures.

Determine whether ratios were calculated before or after adjustments were made to the balance sheet or income statement, such as non-recurring items and inventory or pro forma adjustments. In many cases, these adjustments can significantly affect the ratios. Carefully examine any departures from industry norms.

Types of ratios

Financial ratios can be classified according to the information they provide. The following types of ratios frequently are used:

* Profitability Ratios

* Liquidity Ratios

* Asset Management Ratios

* Leverage Ratios

* Valuation Ratios

Profitability Ratios

The profitability ratios assess the firm’s ability to earn profits on sales, assets, and equity. These are critical to determining the attractiveness of investing in company shares, and investors use these ratios widely.

Gross Profit Margin (GPM)

The gross profit margin is a measure of the gross profit earned on sales. The gross profit margin considers the firm’s cost of goods sold, but does not include other costs.

This Indicates the relationship between net sales revenue and the cost of goods sold. A high gross profit margin indicates that a business can make a reasonable profit on sales, as long as it keeps overhead costs in control.

This is the first level profitability. The GPM depends primarily on the firm’s product pricing and cost control.

The price of the product impacts sales. Production costs such as material, labor and overhead or the cost of purchases affect the cost of goods sold. A firm with a better ability to price products in line with inflation or cost of production, and the ability to control production costs or suppliers will be able to maintain or increase gross margins.

Operating Profit Margin (OPM)

Operating margin is a measurement of what proportion of a company’s revenue is left over after paying for variable costs of production such as wages, raw materials, etc. A healthy operating margin is required for a company to be able to pay for its fixed costs, such as interest on debt. This is also known as operating profit margin or net profit margin.

Operating margin gives an idea of how much a company makes (before interest and taxes) on each rupee of sales.

When looking at operating margin to determine the quality of a company, it is best to look at the change in operating margin over time and to compare the company’s yearly or quarterly figures to those of its competitors. If a company’s margin is increasing, it is earning more per rupee of sales. The higher the margin the better.

The OPM reflects the true profitability of firm’s business in that it is calculated before deducting interest costs which are a result of firm’s financing decision, and taxes which are outside the control of the firm. In other words, regardless of the way the firm is financed, whether through debt or equity, and regardless of the taxes imposed by the government the firm is able to earn this margin.

Net Profit Margin (NPM)

Profit margin is very useful when comparing companies in similar industries. A higher profit margin indicates a more profitable company that has better control over its costs compared to its competitors. Profit margin is displayed as a percentage. It is the profit available for distribution to common shareholders as a percent of sales.

Looking at the earnings of a company often doesn’t tell the entire story. Increased earnings are good, but an increase does not mean that the profit margin of a company is improving. For instance, if a company has costs that have increased at a greater rate than sales, it leads to a lower profit margin. This is an indication that costs need to be under better control.

Return on Assets (ROA)

Return on assets is a measure of how effectively the firm’s assets are being used to generate profits. ROA gives an idea as to how efficient management is at using its assets to generate earnings.

The assets of the company are comprised of both debt and equity, it is important that the return measures used for this calculation reflects income available for distribution to shareholders and debt holders. Both of these types of financing are used to fund the operations of the company.

The ROA figure gives investors an idea of how effectively the company is converting the money it has to invest into net income. The higher the ROA number, the better, because the company is earning more money on less investment.

Return on Equity (ROE)

Return on equity is the bottom line measure for the shareholders, measuring the profits earned for each rupee invested in the firm’s stock. ROE is viewed as one of the most important financial ratios.

It measures a firm’s efficiency at generating profits from every rupee of net assets (assets minus liabilities), and shows how well a company uses investment rupees to generate earnings growth. ROE is equal to a fiscal year’s net income (after preferred stock dividends but before common stock dividends) divided by average Common Equity(excluding preferred shares), expressed as a percentage.