Ratio Analysis

Financial ratios, calculated from the information of financial statements, are used to analyze a firm’s past financial performance.

“Financial ratios are no substitute for a crystal ball”, says it all. Such convenient summaries as ratios are always to be viewed with healthy skepticism. Financial ratios seldom provide answers. Rather they provide the basis for asking the right questions about a firm’s financial performance.

Financial ratios are used to compare the risk and return of different firms in order to help investors and creditors make intelligent investment and credit decisions.

Such decisions range from an evaluation of changes in performance over time for a particular investment to a comparison among all firms within a single industry or peer firm (Matched firm) at a specific point in time.

Purpose and Use of Ratio Analysis

Ratios can be used to compare the risk and return relationships of different firms of different sizes.

Ratios can provide a profile of a firm, its economic characteristics and competitive strategies, and its unique operating, financial and investment characteristics.

Given the differences between industries and of the effect of varying capital structures, and differences in accounting & reporting methods, changes (trends) in a

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ratio and variability over time may be more informative than the level at any point in time.

Four broad ratio categories measures the different aspects of risk and return relationship:

A. Liquidity Analysis — Measures the adequacy of a firm’s cash resources to meet its near-term cash obligations.

B. Efficiency or Activity Analysis — Evaluate revenues and output generated by the firm’s assets.

C. Leverage or Solvency Analysis — Examines the firm’s capital structure in terms of the mix of its debt financing sources and the ability of the firm to satisfy its longer-term debt and investment obligations.

D. Profitability Analysis — Measures the income of the firm relative to its revenues and invested capital.

These ratio categories are interrelated rather than

independent. For example, profitability affects liquidity and solvency, and the assets utilization efficiency impacts profitability.

Motivations for examining data in ratio forms

1. To control for the effect of size differences across forms or over time.

2. To make the data better satisfy the assumptions underlying statistical tools such as regression analysis (e.g. homoscedastic disturbance)

3. To probe a theory in which a ratio is the variable of interest

4. To exploit an observed empirical regularity between a financial ratio and the estimation or prediction of a

© Notes by Dr. Mahmood Osman Imam

varuiable of interest (the likelihood of a firm declaring bankruptcy)

Economic Assumptions

An implicit assumption underlying the use of ratios as a control for size differences is strict proportionality between the numerator and the denominator. This assumption ignores the existence of fixed costs. When there are fixed costs, changes in profits are not proportional to changes in sales.

This impicil assumption of linear relationship between numerator and denominator may be incorrect even in the absence of a fixed component. Operations research theory indicates that optimum relationship between sales and inventory levels is nonlinear and inventory levels may be proportional to the square root of demand.

Ratio Analysis: Cautionary Notes

Ratio computations and comparisons are confounded by the lack or inappropriate use of benchmarks, the timing of transactions, negative numbers, and differences in reporting methods. This section presents some important caveats that must be considered when interpreting ratios.

Benchmarks

Ratio analysis often lacks appropriate benchmarks to indicate optimum levels. (Lender vs equity investors with respect to liquidity).

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Using an industry average as the benchmark may be useful for comparisons within industry, but not for comparisons between companies in different industries.

Even for intraindustry analysis, the benchmark may have limited usefulness if the whole industry or major firms in that industry are doing poorly.

Timing and Window dressing

For annual reports, the fiscal year-end may correspond to the low point of a firm’s operating cycle, when reported levels of assets and libilities may not reflect the levels typical of normal operations. As a result, especially in the case of seasonal businesses, ratios may not reflect normal operating relationships.

Transaction at year-end lead to manipulation of the ratios to show the firm in more favorable light, often called window dressing.

Negative Numbers

The following example illustrate the care that must be taken in ratio analysis when negative numbers occur:

Return on Equity = Income / Equity

Company Income Equity ROEAB

Tk 10,000(10,000)

Tk 100,000(100,000)

10%10%

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Ratio analysis without refence to the underlying data can lead to wrong conclusion as it appears that botth companies earn identical returns on their equity investment.Accoounting Methods

The choice of accopunting method and estimates can greatly affect reported financial statement amountss.

Ratios are not comparable between firms with differing accounting methods or for the same firm over time when it changes accounting methods.

Problems associated with Outlier Observations

An outlier is “an observation which appears to be inconsistent with the reminder of that set of data”.

A useful first step is to determine if the extreme observation arises due to computation reasons:

Is the extreme value due to a recording error? Is the ectreme value due to the denominator of the

ratio approaching zero in a particular year?

A useful second step is to examine accounting classification, accounting method, and economic or structural change as reasons for the extreme observations

The alternatives available to an analyst when faced with extreme observations (not arising from recording errors) include

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Deleting the extreme observation on the grounds that it represents a “true outlier”

Retaining the extreme observation on the grounds that it represents an extreme state of the underlying characteristics

Making adjustments for the economic or accounting factors believed to cause the extreme observation, for example, by imputing the interest payments associated with the “off-balance-sheet” financing

“Winsorizing” the sample, for example, changing the value of the extreme observation to the value of the nearest observation not viewed as “suspect”

“Trimming” the sample by deleting the top N and the bottom N observations.

Market Value Ratios

Financial analysts prefer market value ratios to other measure of performance precisely because they use market data and capital markets convey information to a firm’s management

Price-Earnings Ratio — The price-earnings ratio (P/E) is calculated by dividing current market price by the earnings per share (EPS) of common stock. This ratio shows how much investors are willing to pay for per taka of reported earnings of a firm. Other things being equal, the higher P/E ratio indicates

that market perceives the higher expected future earnings relative to the current reported earnings.

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It is also argued that other things held constant, firms with better growth prospects have higher P/E ratios.

Similarly, the lower a stock’s risk, the higher is its P/E ratio, other things remaining same.

Dividend Yield — The dividend yield is simply dividend per share as a proportion of the current market price of the stock.

Dividend yields are related to the market perception of future growth prospects for firms. Firms with better growth prospects generally have lower dividend yield, while the firm’s risk is positive related to the dividend yield.

Market-to-Book Value (M/B) ratio — The market-to-book value ratio is the ratio of market price of stock to book value per share. This ratio is also used as a proxy for financial distress of a

firm. It is believed, market perceives that a firm is facing financial distress when this ration is less than one and vice-versa.

Tobin’s Q ratio — The Tobin’s Q is the ratio of market value of assets to estimated replacement cost of all assets. The Q ratio uses market value of debt plus equity as the

market value of assets in the numerator, while it uses the replacement value of all assets and not the historical cost value.

Firms have incentive to invest when they have a Q ratio above 1 and will stop investing only when Q is less than 1. Firms with high Q ratios tend to be those firms with high

© Notes by Dr. Mahmood Osman Imam

potential investment opportunities or significant competitive advantage.

© Notes by Dr. Mahmood Osman Imam