Financial statements contain financial data that describes the financial position of a particular firm. Further, business owners, analysts and various other stakeholders analyze, compare and interpret this financial information in order to take key financial decisions. However, such a data is interpreted with the help of certain tools and techniques of financial statement analysis. One such technique used to analyze financial statements is accounting ratios. The other techniques include:
This article talks about accounting ratios in detail. So let’s understand what are accounting ratios. And how different ratios are sued to analyze varied financial statements.
What Are Accounting Ratios?
Accounting ratios are one of the important tools of financial statement analysis. These showcase a relationship between two or more accounting numbers that are taken from the financial statements. Further, such ratios are expressed either as a fraction, percentage, proportion or number of times.
The accuracy or efficiency of accounting ratios as a financial statement analysis tool rests on the financial statements. This is because while calculating a particular financial ratio, the two or more accounting numbers used are taken from such statements. Thus, if the financial statements contain erroneous data, ratios too would depict a false analysis of the company’s financial results.
Also, the accounting numbers used to calculate ratios should have some relationship between them. This is because unrelated numbers would not give any meaningful analysis of the company’s financial results.
Ratio Analysis Example
A financial and industry analysis for Motorola Corporation was undertaken to understand the financial position of Motorola in the year 2002 vis-a-vis its competitors. This analysis was undertaken using financial ratios. However, this study was done for only two segments in which Motorola operates. These include Semiconductor Industry and Telecommunication Industry. The various ratios calculated were as follows:
When Motorola was compared with the other market players in the semiconductor industry for various components, following outcome was seen:
- Motorola was found to be a little less liquid as compared to the industry. This was because both the current ratio and quick ratio (Liquidity Ratios) for Motorola were less than the industry average.
- Motorola’s average collection period for the year 2002 came around 61 days. It was found to be lower than the industry average which came out to be 50 days. This meant that Motorola should analyze its credit policies all over again.
- Both fixed asset as well as total asset turnover ratio for Motorola was higher than the industry average. This suggested that the company was using its assets more efficiently as compared to the industry for generating sales.
- Motorola’s debt ratio as well as debt to equity ratio was higher than the industry average. This pointed towards the fact that Motorola was more leveraged than an average player in the industry. This meant that Motorola was required to pay interests irrespective of the market conditions. Thus, such an analysis describes the poor financial performance on the part of the company.
Similarly, ratios were worked out for Telecommunication Industry players and the same was compared with the financials of Motorola.
Therefore, the above case study explains the relevance of accounting ratios in analyzing the financial statements of a company.
So, let’s understand what are the various types of financial ratios and what are their implications given the above in the backdrop.
Types of Accounting Ratios
Typically, the accounting ratios are classified based on the purpose for which a particular ratio is calculated. Accordingly, ratios can be classified into following categories:
- Liquidity Ratios
- Solvency Ratios
- Activity (Turnover) Ratios
- Profitability Ratios
1. Liquidity Ratios
Liquidity ratio analysis helps in measuring the short-term solvency of a business. That is, a company’s ability to meet its short-term obligations. Liquidity suggests how quickly assets of a company get converted into cash. Further, it ensures uninterrupted flow of cash to meet its current liabilities. Also, liquidity of a company indicates whether it has sufficient funds to meet its day-to-day business operations.
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Types of Liquidity Ratios
1. Current Ratio
Current ratio evaluates a company’s ability to meet its short-term obligations that are typically due within a year. A current ratio lower than the industry average suggests higher risk of default on the part of the company. Likewise companies having too high a current ratio relative to the industry standard suggests that they are using their assets inefficiently.
Current Ratio Formula = (Current Assets/Current Liabilities)
2. Quick Ratio
Quick ratio is a more cautious approach towards understanding the short-term solvency of a company. It includes only the quick assets which are the more liquid assets of the company.
Quick Ratio Formula = (Cash and Cash Equivalents + Marketable Securities + Accounts Receivable)/(Current Liabilities)
3. Cash Ratio
Cash ratio measures company’s total cash and cash equivalents relative to its current liabilities. Such a ratio indicates the ability of the company to meet its short-term debt obligations using its most liquid assets.
Cash Ratio Formula = (Cash + Cash Equivalents/Current Liabilities)
4. Defensive Interval Ratio
This ratio ascertains the time period for which the company can continue to pay off its expenses. These expenses are paid off from the company’s existing pool of liquid assets without receiving any additional cash inflow. Therefore, a higher defensive interval ratio suggests greater liquidity.
Defensive interval ratio (in number of days) = Current Assets/Daily Operational Expenses
Current Assets = Cash + Marketable Securities + Net Receivables
Daily Operational Expenses = (Annual Operating Expenses – Non-Cash Charges)/365
5. Cash Conversion Cycle
Cash conversion cycle determines the time period that transpires from the point when working capital is invested till the time cash is collected by the company. Therefore, lesser the time period between cash inflow and outflow, higher the liquidity. Likewise, greater the time period between cash outflow and inflow, lower the liquidity.
Cash Conversion Cycle = Days of Inventory Outstanding + Days Sales Outstanding – Days Payable Outstanding
2. Solvency Ratios
The term solvency refers to the ability of the company to meet its long – term debt obligations. Solvency ratios help in determining the amount of debt used by the company as against the owner’s fund. Further, these help in ascertaining if the company’s earnings and cash flows are sufficient to meet interest expenses as they accrue in future.
Types of Solvency Ratios
1. Debt To Asset Ratio
This ratio measures the amount of debt taken by a business as against the equity. It helps in determining the financial leverage of the business.
Debt To Asset Ratio Formula = Total Debt/Total Assets
2. Debt To Capital Ratio
This ratio also helps in measuring the financial leverage of the company. It helps the investors to have a fair idea about the financial structure of the company. Thus, investors get an understanding if it is good to invest in a particular company or not. So, higher debt equity ratio indicates higher risk associated with the company.
Debt to Capital Ratio = Debt(Both Short-Term and Long-Term Debt)/Total Capital (Debt + Shareholders Equity)
3. Debt To Equity Ratio
This ratio evaluates the amount of debt capital of the company as against its equity capital. Higher the ratio, weaker the solvency of a company.
Debt To Equity Ratio Formula = Total Debt/Total Shareholders Equity
4. Interest Coverage Ratio
Interest Coverage Ratio determines number of times the EBIT (Earnings before interest and taxes) of a company can cover its interest payments. This ratio thus indicates the solvency of a firm. Higher the interest coverage ratio, greater is its solvency.
Interest Coverage Ratio Formula = EBIT/Interest Payments
5. Fixed Charge Coverage
This ratio determines number of times earnings (before interest, taxes and lease payments) of a company are able to cover the interest and the lease payments of the company. Thus, a higher fixed charge coverage ratio indicates greater solvency suggesting that the company can pay off its debt from its earnings.
Fixed Charge Coverage Ratio Formula = (EBIT + Lease Payments)/(Interest Payment + Lease Payment)
3. Profitability Ratios
Profitability ratios determine the ability of the company to generate profits as against : (i) Sales, (ii) Operating Costs, (iii) Assets and (iv) Shareholder’s Equity. This means such ratios reveal how well a company makes use of its assets to generate profitability and create value for shareholders.
Types of Profitability Ratios
1. Gross Profit Margin Ratio
2. Operating Profit Margin Ratio
Operating Profit Margin is calculated by dividing operating Profit with Net Sales. Where the operating profit is the difference between gross profit and sum of operating costs such as selling, general and administrative expenses.
Operating Profit Margin Formula = Operating Profit/Revenue
3. Pre-Tax Margin Ratio
Pre-Tax Margin Ratio is calculated by dividing Pre-Tax Income with the total revenue. Where Pre-Tax Profit is nothing but Operating Profit less interest.
Pre-Tax margin Formula = Earnings Before Tax But After Interest (EBT)/Revenue
4. Net Profit Margin Ratio
Net Profit Margin refers to the percentage of profit a company generates from its revenues. In other words, this ratio indicates the amount of net profit a company is able to generate for every unit of increase in revenue.
Net Profit Margin = Net Income/Revenue
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5. Return On Assets Ratio
Return on assets indicates return generated by a company on its assets. A higher return on assets ratio indicates that the company is able to generate more income from the given amount of assets.
Return On Assets Formula = (Net Income + Interest (1-Tax Rate))/Average Total Assets