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Ratio Analysis: Understanding the language: Session I-C

Concept Title: Introduction to Ratios

Ratios define relationships between two variables. A financial ratio is computed by dividing the dollar amount of one item reported in a financial statement by the dollar amount of another. The purpose of ratio analysis is to express relationships between two variables so that they are easy for analysts to interpret and compare with other information available. Intra-firm ratio analysis is the comparison of ratios of a particular firm over a period. The task involves interpretation of ratio values by examining the behavior of a firm’s financials over a period.

Hence, it is dynamic in nature. Trend Analysis is another name for intra-firm ratio analysis.

Inter-firm ratio analysis is the comparison of two firms that are operating in the same industry. Such firms are thought of as being similar (not same) to each other in at least a few respects. To evaluate the financial situation of a company, analysts compare its ratios with those of two or more similar firms.

There is no time dimension involved in inter-firm analysis; analysts may compare ratios for a particular accounting period or for a number of accounting periods. The key is to compare one business with another of its kind.

Concept Title: Ratios – Comparative Analysis

Concept Description: Details the two types of comparative analysis that can be performed using ratios

Industry Averages

When evaluating the financial health of a company, analysts perform an overall industry financial analysis. They do this to highlight changes and trends that have an impact on the entire industry.

What will happen when Mindboggle Inc., the largest player in the industry, installs another plant to increase its production, thereby affecting the capacity of the entire industry?

Can one know for sure just by studying the ratios of Mingboggle Inc? The answer is no. In order to evaluate the impact of this increased production, the analyst must study the production of the entire industry.

The industry average is an average of the ratios of all companies within the industry. The analyst compares the performance of individual organizations with the industry average to determine whether the company is doing better or worse than the rest of the industry.

The use of industry averages assumes that firms within the industry produce and/or market the same product and therefore have the same business characteristics. It is this similarity of characteristics that make individual and industry ratios comparable.

However, no two businesses have exactly the same operational characteristics. Therefore, industry averages do not represent a target or norm that a particular firm must achieve to receive a satisfactory rating. Rather, they provide only a general guideline as to what is good, satisfactory or poor. A ratio of an individual firm that departs from the norm should only be interpreted to mean that further investigation and/or analysis is required.

Four major sources of industry averages, in terms of financial ratios, are:

  1. Dun & Bradstreet’s Industry Norms and Key Business Ratios – 14 different ratios are calculated in an industry-average format for 800 different types of businesses
  2. Robert Morris Associates’ Annual Statement Studies
    – 16 different ratios are calculated in an industry-average format
  3. Troy Leo’s Almanac of Business & Industrial Financial Ratios
    – 22 financial ratios and percentages are provided for all major industries
  4. Federal Trade Commission Reports – publishes quarterly financial data, including ratios

Trend Analysis

If a ratio is calculated for a single accounting period, it will not yield any meaningful information. This is why ratio analysis, or any kind of financial analysis, is performed on a continuous basis.

Trend Analysis is to calculate a particular ratio, over a period (that is for different accounting periods) .

For example, a research analyst in the fashion industry would be interested in knowing how people’s preferences in terms of clothing, have changed every summer in the past five years. In the same way, investors would also be interested in finding out what path a firm’s Earnings per Share has treaded over the past five years.

The comparison between different time-periods helps in identifying an upward or downward trend present in a business’ earnings, profitability, debt etc. Trend analysis gives us a clue as to whether a firm’s financial situation is improving, remaining constant or deteriorating.

Concept Title: The many faces of ratio analysis

The analysis of a firm’s financial ratios provides deep insights about the management of a company. It depicts the strategic decisions that are being taken, the current cost structure, variations or stability in profits and provides information about other drivers of business. Based on this information, an analyst or manager will take an investment or management decision.

The analyst, however, must give careful thought as to which ratios best express the relationships relevant to the area of immediate concern. For example, if you were concerned with whether a particular business’ high level of debt affects profitability positively or negatively, you would try establish relationships between the firm’s capital structure (to what extent assets are financed by equity and/or debt) and profitability.

It is also important to realize that although a single ratio establishes a relationship, it may not have any significance when used alone. Therefore, ratios should be compared to standards such as an industry average, ratios of other competitive businesses and the historical record of the company under study.

Computing financial ratios is like taking a picture: the results reflect a situation at just one point in time. This is because the basis of all ratio analysis is the accounting information present in financial statements. Comparing ratios with industry averages, and with ratios of other strategic competitors is more likely to result in meaningful statistics. The analyst can then use these figures to identify and evaluate the strengths and weaknesses of a business.

Not all ratios are relevant to all types of industries and companies. For example, the ratio for Accounts Receivable Turnover and Average Collection Period are not meaningful at all for a company that conducts its business on cash only. However, these ratios are very important for those that carry out their entire business on credit. They can spell out if a company is heading towards disaster !!!

Ratios serve as tools of control. At most, a ratio will identify that the financial health of the business is just right. However, it is up to the analyst to investigate the reasons for all the problems. The ratios don’t explain the reasons. They only identify what areas of operations need to be analyzed more intensely.

As an analyst, you may want to ask the following questions:

  1. Is the business making enough money?
  2. Is the company effectively utilizing its assets?
  3. What is the risk of the business defaulting on its obligations?
  4. What is the short term and long term cash position?
  5. Would someone else want to invest in this business?

The return earned by investors in any business is a function of Profitability, Productivity and Leverage. This is what the first three questions ask. Liquidity (short term cash position of a company) is a great indicator of short-term cash problems and long-term managerial issues. This is what the fourth question asks. Finally, valuation (as addressed in question 5) concentrates on the cost or premium that has to be paid for a piece of the action.

Based on these issues and questions, most ratios are categorized as

  1. Profitability Ratios
  2. Productivity Ratios
  3. Leverage Ratios
  4. Liquidity Ratios
  5. Valuation Ratios

With information and mechanical processes, there is always a caveat. There are limitations when it comes to numbers. Numbers usually work with static situations and statements, which is why a financial analyst can never stress the importance of qualitative analysis and managerial judgment enough. One of the main issues with ratio analysis is that the analysis is performed with historical data. The key word here is “historical”, which tells us that we are simply reviewing the past.

In addition, ratio analysis is based on accounting information present in the financial statements (usually the Balance Sheet and the Income Statement). What happens when the accounting information is incorrect? Under this situation, Ratios will depict unrealistic information, which defeats the purpose of conducting such an analysis in the first place.

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