## Ratio Analysis of Financial Statements

written by: •edited by: Wendy Finn•updated: 3/1/2011

Ratio analysis is an important tool for users of financial statements to extract useful information. Ratio analysis of financial statements may assist potential investors in analyzing the solvency and profitability of the enterprise.

• slide 1 of 8

Modern financial statements contain a large amount of information about an enterprise, and the users of the accounts must have a framework for selecting and analyzing information that is relevant to their particular needs. Ratio analysis of financial statements is a tool for simplifying the task of understanding the information presented in the pages of the financial statements. These ratios help management to plan ahead, and indicate areas where greater efficiency is required. Trends shown by financial and accounting ratios can help in compiling forecasts and budgets. Ratios also help management and investors to compare the performance of an enterprise with its competitors, and highlight areas where improvement is required. Financial institutions may also use ratio analysis in arriving at a decision on whether to lend to an enterprise.

• slide 2 of 8

### Liquidity Ratios

The liquidity ratio, or acid test, is found by dividing current assets, minus inventory, by current liabilities. This ratio compares the amount of cash, or assets such as debtors, that can quickly be turned into cash, with the amount of liabilities that need to be met in the short term. This is a very rough measure of the short term liquidity of the enterprise, and should result in a value of more than one, if the enterprise's liquidity position is adequate at any particular point in time. A value of less than one may indicate that the enterprise might have difficulty in meeting its debts as they fall due, though this is only a first indication and other aspects of the enterprise’s financial position (such as its ability to sell its inventory quickly), would have to be considered to gain a full view of the short term liquidity position.

The current ratio (or working capital ratio), is computed by dividing current assets, by current liabilities. The significance of this ratio as a guide to liquidity, depends on a number of factors including the rate of turnover of stock. It is generally considered that a current ratio of 1.2 or above, is a sign of satisfactory short term liquidity.

• slide 3 of 8

### Profitability Ratios

The financial statements show whether the business has been profitable in a particular accounting period, and comparison with previous years will show if the profit is increasing or decreasing. However the use of accounting ratios can indicate whether the profit is growing, in proportion to the size of the business, as represented by the level of turnover, assets or capital invested in the business. Looking at profit as a percentage of turnover or assets, therefore gives valuable information about the business.

A ratio that is easily taken from the accounts is the gross profit ratio, this being the gross profit as a percentage of turnover. A decline in this ratio from one year to the next could indicate that the direct costs of production are increasing too much, and need to be controlled, or that prices need to be increased. It can also be useful to compare the gross profit percentage with that of other enterprises in the same industry, as this might be an indication of how the company is performing in the context of the market in which it operates.

The net profit margin looks at the net profit as a percentage of turnover. If the net profit margin is declining, this could be a sign that overhead expenses are increasing too rapidly compared to the growth of the business. The enterprise may need to look at the level of general overheads, such as administrative expenses, and look at ways of reducing them. Comparison with the net profit percentage of competitors is also a worthwhile exercise, to gauge the efficiency of the enterprise compared to its competitors.

Another way to gauge how profitably the enterprise is operating, is to look at the Return on Assets (ROA). This measures the net profit as a percentage of the net assets of the enterprise. The ratio looks at how efficiently the enterprise is making use of the assets used in the business, and is therefore one way in which the management performance can be gauged. Ratio analysis of financial statements can, therefore, be used within and outside the enterprise, to give an idea of how well the management is performing, as well as being used by investors to see how the enterprise is developing.

• slide 4 of 8
A number of aspects of a company's business can be measured by ratio analysis of financial statements. These aspects include the rate at which debts are being collected and the inventory turnover. The level of gearing is also important and can be measured by using the debt to equity ratio or looking at the level of interest cover.
• slide 5 of 8

### Efficiency Ratios

While the profitability ratios look at how the whole business is performing, ratio analysis of financial statements can also show how efficiently certain aspects of the business are being managed. The average collection period for debts, expressed as the number of days debts are outstanding before being collected, is found by dividing debtors by turnover, and dividing the result by 365. This therefore shows how promptly the customers are paying their bills and may indicate, if it is too high, that the company’s policy (or enforcement of its policy) in relation to debtors, must be tightened up.

Similarly, the days taken to pay suppliers can be measured by dividing creditors, by purchases, and dividing the result by 365. This may be useful for a business deciding whether to extend credit to another business, by looking at the accounts of that business, and examining how long they need to pay their suppliers. The ratio is used by credit reference agencies in compiling a profile of a business for the benefit of potential suppliers of the business.

The inventory turnover ratio can show how quickly the business is turning over its inventory, turning stock into sales. The ratio is computed by dividing the cost of goods sold, by the value of inventory. This shows the number of times the inventory is being turned over in a year. Where stock is not being turned over quickly enough, this may indicate that the inventory levels are too high, and that a more efficient stock control system is required.

The growth of overhead expenses in relation to the size of the business, can be assessed by dividing the overheads, by the turnover. If this calculation is performed over a number of periods, it can show the trend of overheads growth, and the business can determine if the level of overheads is growing faster than the business as a whole.

• slide 6 of 8

### Long Term Solvency Ratios

The gearing ratio, is the ratio of borrowed funds to the enterprise’s equity capital, looking at the size of the enterprise’s debt in relation to the equity of the business. This ratio, therefore, examines the extent to which the enterprise is funded by third party loans, as compared with capital from the owners of the business. A ratio of 1:1 would be considered to be satisfactory, but the overall financial position of the business has to be taken into account when determining if any particular value for the ratio is satisfactory. The higher the leverage of an enterprise, the more risk may attach to investing in the business, though this is only a rough guide and more analysis would be needed to establish the true position. Comparisons of the gearing of an enterprise with other companies in the same industry can also be useful.

In addition to the debt to equity ratio, which is the debt divided, by the equity of the enterprise, the level of gearing can also be measured by the interest cover. This is found by dividing the earnings before interest and tax (EBIT), by the interest payable on the borrowing. This ratio may be examined by financial institutions considering lending to the enterprise, and it is sometimes considered that the ratio should have a value of at least 3. Where the enterprise has high gearing it may be more vulnerable when there are downturns in business, as it must continue to pay interest to the loan creditors, whereas an enterprise funded largely by its own equity funds, does not need to pay interest and may be more flexible as regards the dividends it pays out on its equity capital.

• slide 7 of 8

### Limitations of Accounting Ratios

Accounting ratios are based on the financial statements, which have their limitations. Figures in the financial statements may be affected by accounting policies on depreciation, leasing or provisions, although the underlying reality of the business is the same, regardless of which accounting policy is selected. Some important non-financial realities, such as the quality of the management and workforce, do not appear in the accounts. There may be valuable intangible assets that are undervalued in the accounts, or do not appear at all.

Often, a single accounting ratio does not convey much information, and it is necessary to compare the ratio with trends in previous years, or with the ratios of competitors. Comparison with ratios of competitors may be misleading, because of differences in the structure and strategy of the different enterprises. Ratio analysis of financial statements is useful, but the ratios are open to different interpretations depending on the point of view of the user of the financial statements. Accounting ratios should be regarded as a first step in the analysis of financial statements, serving as an indicator that should lead to deeper research.

• slide 8 of 8