Executive Summary
Financial ratios show associations between various factors of the business operations. They entail comparison of income statement and balance sheet’s elements. These ratios are grouped into four distinct categories; liquidity ratios (Quick and current ratios), profitability ratios (ROE and ROA), leverage (debt-equity ratio and debt-to-assets ratio) and investors’ ratios (EPS and P/E). These ratios are beneficial since they summarize the financial statements and make it easy for investors to understand but they do have some drawbacks like use of irrelevant information in making future decision and different users of accounting information use different terms to depict financial information among others. Therefore, investors should be aware that ratios are good measures but they cannot be used solely to make financial decision as a result of these drawbacks. Thus, investors should seek other measures like non-financial analysis by looking at management style and experience, and morale of the employees among others.
Introduction
Security analysts and investors frequently use ratios to evaluate the weaknesses and strengths of various firms. Ratio analysis is important in analyzing financial statements which is a crucial step before investing in any firm since it quantifies the firm’s performance in various factors like the firm’s ability to be profitable, ability of the firm to pay debt (liquidity of the firm), stability of the firm in paying long-term debt as well as the ability of the company to manage its assets (efficiency). Ratios normally compare the firm’s performance in a certain period and against other firms in the industry in order to determine the firm’s weaknesses and strengths and for investors or managers to take suitable investment and financing decisions (Liu and O’Farrell, 2009).
It is hard to deduce the firm’s performance from two or three simple figures. Nonetheless, in practice some diverse ratios are frequently calculated during strategic planning activities and in general because financial ratios do offer information on relative performance of the firm. Particularly, careful evaluation of a mixture of the ratios might assist in making a distinction between companies that will in the end not succeed from those companies that will succeed. Therefore, ratio analysis is discussed, and some benefits and limitations linked with their usage are emphasized. Lastly, ratios are more relevant when used to evaluate firms in the same industry (Nd.edu, 2010).
Liquidity ratios
For survival, companies should be able to pay creditors and other short-term obligations. In this case, firm should be concerned with its liquidity by use of measures like quick ratio and current ratio. The major difference between these two ratios is that, the former does not use stock while the latter does. Quick ratio is a conventional standard; if it is more than one it implies that the firm is not facing liquidity risk and that is it can be able to pay current liabilities. And if not more than one but current ratio is above one, the firm’s status is more composite. In such a situation, valuation of stocks and stock turnover are clearly crucial (Nd.edu, 2010).
Stock valuation methods life LIFO and FIFO may contaminate current ratio. This is because firms use different methods when valuing stocks, which may overvalue or undervalue the stocks, making it hard to compare firms using current ratio. This means that quick ratio is the most preferred liquidity ratio (Nd.edu, 2010). Consider Hyatt Hotel Corporation’s quick ratio of 2010 and 2009, the firm’s liquidity position decline in 2010, implying that the firm was using more of current liabilities in 2010 compared with 2009. Compared to other firms in the industry like Red Lion Hotels and Intercontinental Hotels Group (IHG), Hyatt is more liquid than its competitors who are facing liquidity risk since the ratio is less than one as shown by Table 1.
Leverage
Companies are funded by mixture of equity and debt and the optimal capital structure depends on the tax policy, corporate risk and bankruptcy costs. Two measures are used, debt-equity ratio and debt-to-assets ratio (Nd.edu, 2010).
Just like liquidity ratios, leverage ratios pose some issues in interpretation and measurement. In this case equity and assets are normally measured through book value in financial statements, the book value does not depict the company’s market value or value the creditors would receive if firm is liquidated (Nd.edu, 2010).
Ratios like the debt-to-equity ratios differ significantly crossways industries due to industry’s characteristics and environment.
A utility firm that is more stable can operate comfortably with comparatively superior debt-equity ratio while a cyclical firm like recreational vehicles manufacturer normally requires lower ratio (Nd.edu, 2010).
Frequently analysts use debt-equity ratio to establish the capability of the firm to generate additional finances from capital market. A firm with significant debt is frequently considered to have less additional-funding capacity. In reality, the overall funding capacity of the firm possibly depends on the new product’s quality that the firm is wishing to pursue with its capital structure. Nonetheless, given bankruptcy threat and costs, a superior debt-equity ratio might make future refinance hard (Nd.edu, 2010).
For instance, debt-equity ratio of Hyatt declined in 2010 indicating a reduction in the gearing level of the firm compared to the year 2009. Compared to its competitors, Red Lion and IHG, Hyatt is less geared and IHG is highly geared among the three firms as it is more than 100%. This implies that IHG is facing high financial risks while Hyatt’s financial risk is very low as shown by Table 2.
Profitability
ROE and ROA are measures of firm’s profitability and are widespread in firms. Equity and assets as utilized in these ratios are book values. Therefore, if fixed assets were bought in the past three years at a lower price, this means that the present performance of the firm might be overstated through the utilization of past information. As a consequence, accounting returns of the investment are normally not correlated well with real economic project’s IRR (Nd.edu, 2010).
It is hard to use these two ratios in merger deals to measure the firms’ performance. Assume we have a firm X that used to earn net profit of $1,000 on the assets with book value of $2,000, for a large 50% as ROA. This firm is currently acquired by another firm Y that transfer the additional assets to its balance sheet at the buying price, presuming that the transaction is treated through the use of accounting method of purchase. Actually, the purchase price will be more than $2,000, higher than the assets book value, for a possible acquirer must pay higher price for privilege of gaining $1,000 on an ordinary basis.
Assume further the firm Y pays $3,000 for X’s assets. After the purchase, it will emerge that X’s returns have decreased, Firm X continues to make $1,000 but currently the asset base is at $3,000, and thus the ROA reduces to 33.33%. In reality, ROA might reduce due to other factors like rise in depreciation of the additional assets obtained. However, nothing has happened to net income of the company but only its accounting has changed and not the firm’s performance (Nd.edu, 2010).
ROE and ROA also have another problem in that analyst tend to concentrate on the single years performance, years that might be idiosyncratic. On average, one must evaluate these ratios over some years through use of average to separate returns that are idiosyncratic and attempt to identify patterns (Nd.edu, 2010).
For example, Hyatt’s ROE and ROA indicate that the firm’s profitability increased in 2010 implying that the firm’s efficiency in managing production costs, operating costs and cost of sales as well as assets had improved, while IHG was the most profitable firm among the three firms with, Red Lion being the least profitable firm as shown on Table 3.
Investors’ ratios
These ratios are determined from the performance of the stock market and they include; P/E, Dividend Yield and EPS. EPS is widely used amongst the three ratios. In reality, it is shown on financial statements of the listed firms. EPS indicates how much each share invested in the firm has earned. This means that it is not a useful statistics since it does not show how many fixed assets the company utilized to generate those incomes, and thus nothing on profitability. It also does not show how much the shareholder has paid for each share invested in the firm for rights over the annual income. In addition, the accounting principles used to determine the income might alter these ratios and treatment of stock is also challenging (Nd.edu, 2010).
P/E ratio is also used and it is reported mainly in the daily newspapers. P/E ratio that is high indicates that the investors deem that the firm’s future prospects are superior to its present performance. They are paying more for every share than company’s present income warrant. And still the income is treated in different ways in diverse accounting practices (Nd.edu, 2010).
For example, in 2010 the EPS of Hyatt increased from 0.28 to 0.29 this means that for every share invested in the firm generated $0.29 of the firm’s earnings. Compared to competitors, Red Lion has the least EPS while IHG has the highest. The Hyatt’s P/E indicates the investors in 2009 and 2010 would take 106.46 and 157.79 years to recover their initial investment in shares from the earnings generated by that investment in the firm respectively, while its competitors’ investors will take less years for them to recover their initial investment as shown by Table 4.
Benefits and limitations
Financial analysis involving ratios is a helpful tool for the users of the financial statements. Ratio analysis has some advantages that include; first, they simplify firm’s financial statements and also emphasize significant information in straightforward form quickly. Thus a user of the firm’s financial statements can judge the firm by only looking at some figures instead of examining the entire financial statements. Finally, the analysis assists in comparing firms of varying magnitude within the industry and can be used in comparing one firm financial performance over a particular period of time, normally referred as trend analysis (Accountingexplained.com, 2011).
On the other hand, the analysis poses some disadvantages in that information from the financial accounting is influenced by assumptions and estimates. Accounting standards let varying accounting policies that damages comparability and thus in such circumstances ratio analysis is used less. The ratio analysis describes relationships between historical information while the users are mostly concerned on the present and the future information. Different firms operate in diverse industries with diverse environmental conditions like market structure, and regulation among others. These factors are so important in that an evaluation of the two firms from dissimilar industries may be misleading (Accountingexplained.com, 2011).
For instance, a Chinese firm’s financial ratios might be exposed to misunderstanding by an investor from US as a result of variations in the accounting principles, institutional and culture environments, economic environments and business practices. China adopted IFRS ever since 2007 whilst firms in the United States are still applying U.S. GAAP to report accounting information (Liu and O’Farrell, 2009). The culture of China is centred on the relationships while culture of America is centred on the individuals. In addition the variation between collectivists and individualists, people of China have a tendency of being risk-adverse and conservative.
China is a socialism nation in evolution from the planned economy to the market economy while US on the other hand, is a nation having a market capitalism. These two nations have different GDP growth with China having the highest compared to US. Such variations may decrease the comparability and comprehension of information from financial accounting. The Chinese firms may be found to have lower Asset Turnover ratio probably as a result of firm’s high growth rate, superior Average Collection Period probably as a result of overstated debtors account and the requirement to guarantee steady employment, and a lower Debt to Net Worth ratio probably as a result of risk averseness nature of the Chinese individual investors (Liu and O’Farrell, 2009).
These disadvantages stirred researchers to investigate and make use of methods such as negative examination elimination, trimming, square root, logarithmic, logit as well as utilizing rank transformation in order to attain more projective independent variables (Bahiraie, 2008).
New practices
During utilization of ratios managers are more concerned with misinforming than informing. Managers therefore seek to reduce discretionary costs like advertising, training, research and maintenance among others, with the aim of increasing net profit whilst having a negative effect on the future income potential. New management might likewise write-down assets value to decrease the amortization and depreciation charges for future financial years. An entrepreneur might evade restocking inventory at some point in time especially before the end of the financial year in order to raise the firm’s current ratio. Short-term payment of the current liabilities or debt just before the end of the financial year will accomplish similar outcome. Retained earnings may be corrected for the future stock price decrease and afterwards recorded as net income.
Frequently an assessment of a sequence of the annual statements instead of one year will emphasize such practices. More excessive practices are normally avoided by companies that are required to answer to the regulatory agencies in order to be listed on the stock market or exchange (Best, 2009).
Conclusion and recommendation
Ratios are normally utilized in strategic planning. These ratios may be manipulated through opportunistic practices of accounting. Nonetheless, taken collectively and utilized sensibly, they might assist in identifying companies or business divisions in particular problem. And finding new ventures that are profitable needs more effort. Therefore, investors should carry out their own analyses to determine which firm to invest in. Due to limitations of these ratios, the investors should also consider the non-financial analysis like the leadership style, morale of employees and experience among others.
References
Accountingexplained.com. (2011). Advantages and limitations of financial ratio analysis. Web.
Bahiraie, A., Ibrahim, N., Mohd, I. and Azhar, A. (2008). Financial Ratios: A new geometric transformation. International Research Journal of Finance and Economic, 20:165-171.
Best, B. (2009). The uses of financial statements. Web.
Liu, C. and O’Farrell, G. (2009). China and U.S. financial ratio comparison. International Journal of Business, Accounting, and Finance, 3(2): 1-13.
Nd.edu. (2010). Financial ratio analysis. Web.