Financial Ratio Analysis Notes

Financial ratio analysis is conducted by managers, equity investors, long-term creditors, and short-term creditors. What is the primary emphasis of each of these groups in evaluating ratios? Managers use financial statements to monitor measurements like debt leverage, costs, sales, assets and liabilities. Financial statements help managers assess achievement of financial goals.

Analysis of financial ratio helps equity investors to know whether their investment earnings any return or not. The emphasis would be placed on whether the company earning higher or lower return compared to previous year, the industry average and the biggest competitors within the same industry. Analysis of financial ratios assists Short term creditors to know the ability of company to pay their short term obligation. Calculation of Current ratio, receivable turnover and accounts payable are some of the ratios that helps short term creditors to analyze company’s credit history. Financial ratios analysis helps long term creditors to know company’s ability to meet interest expenses and long term obligations on time. Times interest earned ratio, debt to total assets turnover ratio, debt to shareholders equity ratio are some of the ratios that are helpful for long term creditors.

Over the past years, M. D. Rryngaert & Co. has realized an increase in its current ratio and drop in its total assets turnover ratio. However, the company’s sales, quick ratio, and fixed assets turnover ratio have remained constant. What explains these changes? The changes explain that company was not able to successfully manage their inventories. Due to the increase in inventory both current assets and current ratio increased whereas total assets turnover decreased. Since inventory does not affect quick ratio and fixed assets turnover, these ratios remain constant. Company’s sales have remained constant but inventory has increased. This situation shows that company is losing their money.

Profit margins and turnover ratios vary from one industry to another. What differences would you except to find between a grocery chain such as Safeway and steel company? Think particularly about the turnover ratios, the profit margin, and Du Pont equation. Profit margin is the ratio between revenue and income. Business with higher profit margin have lower cost of sales and therefore a high profit while business with lower profit margin have higher cost of sales. Thus businesses with a low margin needs to have high volume to sales to make up for the low margin. Turnover ratios show how many times a year company is replacing their inventories or collecting their debtors. Higher turnover indicates that company is producing and selling their products quickly and lower turnover ratio indicates that company is producing and selling their products late. Grocery chains like Safeway are business that have lower profit margin, high turnover ratio and therefore a higher volume of business transaction whereas a steel company is a business that has a higher profit margin, low turnover ratio and therefore a lower volume of business transactions.

Why is it sometimes misleading to compare a company’s financial ratios with those of other firms that operate in the same industry? Answer: Within the same industry some of the firm may operate in their growth stage of business life cycle and some may operate in maturity and introduction stage. The size of the firm may also vary from company to company within the same industry. Some firm may diversified their product all around the globes and some may operate locally. All these differentiations affect the company’s financial performance. A growing company may have negative cash flow and negative return because of huge investment in fixed assets but a matured company may have positive cash flow. In the above example even though growing company looks weaker it will grow in the future and earned highest return but currently when investor compare these two they will definitely make wrong decision. Therefore comparing financial ratios without considering other forces within the same industry is some time misleading.