No banker would lend or advance facilities to a company until he has analysed its financial statement and compared its performance to that it achieved in previous years and with that of other companies. This can be difficult at times because:
a) The size of the companies may be different.
b) A company's balance sheet composition may have changed significantly. It may have issued share or increased/reduced borrowings.
It is in the analysis of financial statements that ratios are most useful because they help the banker to compare the strengths, weaknesses and performance of companies and to also determine whether it is improving or deteriorating in profitability or financial strength.Ratios express mathematically the relationship between performance figures and/or assets/liabilities in a form that is easily understood and interpreted. Otherwise one may be confronted by a battery of figures that are difficult to draw meaningful conclusions from.
It should be noted that figures by itself will notenable one to arrive at a conclusion on a company's strengths or performance. Sales of Rs 500 crores a year or a profit of Rs 100 crore in a year may appear impressive but one cannot be impressed until this is compared with other figures such as its assets or net worth.
It must be remembered that when comparing one figure with another the relationship should be clear and logical. Otherwise no useful conclusion can be arrived at. Thus a ratio expressing sales as a percentage of trade creditors or investments is meaningless as there is no commonality between the figures.On the other hand a ratio that expresses the gross profit as a percentage of sales indicates the mark up on cost or the margin earned.
There is no point in computing just one ratio as it will not give the whole picture but just one aspect. It is only when all the different ratios are calculated and arranged that the complete state of the company emerges and it is important that an investor has as much information as possible before heactually invests.
Ratios can be broken out into four broad categories:
A) Profit and Loss ratios
These show the relationship between two items or groups in a Profit and Loss Account or Income Statement. The more common of these are :
Sales to cost of goods sold
Selling expenses to Sales
Net Profit to Sales
Gross Profit to Sales
B) Balance Sheet RatiosThese deal with the relationship in the Balance Sheet such as :
Shareholder's equity to Borrowed Funds
Current assets to Current Liabilities
Liabilities to Net Worth
Debt to Assets
Liabilities to Assets
C) Balance Sheet and Profit and Loss Account RatiosThese relate an item on the Balance Sheet to another in the Profit and Loss Account such as :
Earnings to shareholder's funds
Net Income to assets employed
Sales to Stock
Sales to Debtors
Cost of Goods sold to creditors
D) Financial Statements and MarketRatiosThese are known normally as market ratios and are arrived at by relating financial figures to market prices
Market value to earnings.
Book value to market value
Bankers normally group ratios into categories to enable them to easily determine the strengths or weaknesses of a company:
Profitability
Liquidity
Leverage
Debt Service Capacity
Asset Management/Efficiency
Margins
Earnings
Ratios being measured must always be consistent and valid. The length of the periods being compared should be similar. Large non recurring income or expenditure should be omitted when calculating ratios calculated for earnings or profitability. Otherwise the conclusions arrived at will be incorrect.Ratios do not provide answers. They suggest possibilities. Investors must examine these possibilities along with general factors that would affect the company such as its management, management policy, government policy, the state of the economyand the industry to arrive at a logical conclusion and he must act on such conclusions.
Ratios are a tremendous tool in interpreting financial statements but their usefulness is entirely dependant on their logical and intelligent interpretation.
Copyright © 1998 Indian Express Newspapers (Bombay) Ltd.
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