We can use several tools to evaluate a company, but some of the most valuable are “financial ratios“. Ratios are an analyst’s microscope: they allow us get a better view of the firm’s financial health than just looking at the raw financial statements. Ratios are useful both to internal and external analysts of the firm.
For internal purposes: ratios can be useful in planning for the future, setting goals, and evaluating the performance of managers. External analysts use ratios to decide whether to grant credit, to monitor financial performance, to forecast financial performance, and to decide whether to invest in the company.
Calculating financial ratios is a pointless exercise unless you understand how to use them. One overriding rule of ratio analysis is this: A single ratio provides very little information, and may be misleading. You should never draw conclusions from a single ratio. Instead, several ratios should support any conclusions that you make. With that precaution in mind, there are several ways that ratios can be used to draw important conclusions.
With this “Financial Statement Analysis Tools” post series, I do hope it will aid you a basic knowledge about financial ratio, and able to : describe what financial ratios are and who uses them, define the five major categories of ratios (liquidity, efficiency, leverage, coverage, and profitability), calculate the common ratios for any firm by using income statement and balance sheet data, use financial ratios to assess a firm’s past performance, identify its current problems, and suggest strategies for dealing with these problems, calculate the economic profit of a firm.
We will look at many different ratios, but you should be aware that these are, of necessity, only a sampling of the ratios that might be useful. Furthermore, different analysts may calculate ratios slightly differently, so you will need to know exactly how the ratios are calculated in a given situation. The keys to understanding ratio analysis are experience and an analytical mind.
We will divide our discussion of the ratios into five categories based on the information provided [click on link you want to read further]:
Liquidity Ratios, describe the ability of a firm to meets its current obligations. Consisted of:
- The Current Ratio
- The Quick Ratio
Efficiency Ratios, describe how well the firm is using its investment in assets to produce sales, consisted of:
- Inventory Turnover Ratio
- Account Receivable Turnover Ratio
- Average Collection Period
- Fixed Asset Turnover Ratio
- Total Asset Turnover Ratio
Leverage Ratios, reveal the degree to which debt has been used to finance the firm’s asset purchases, consisted of:
- The Total Debt Ratio
- The Long-Term Debt Ratio
- The Long-Term Debt to Total Capitalization Ratio
- The Debt to Equity Ratio
- The Long-Term Debt to Equity Ratio
Coverage Ratios, are similar to liquidity ratios in that they describe the ability of a firm to pay certain expenses. Consisted of:
- The Times Interest Earned Ratio
- The Cash Coverage Ratio
Profitability Ratios, provide indications of how profitable a firm has been over a period of time. Consisted of:
- The Gross Profit Margin
- The Operating Profit Margin
- The Net Profit Margin
- Return on Total Assets
- Return on Equity
- Return on Common Equity
- The Du Pont Analysis
At the end, we are also going to take a brief conclusion, with:
Analysis of ROYAL BALI CEMERLANG’s Profitability Ratios, so that you can see how to see a financial statement ratio analysis in the whole of a company.
Trend Analysis, which involves the examination of ratios over time.
Company Goals and Debt Covenants and Comparing to Industry Averages
Economic Profit Measures of Performance
Summary of Financial Ratio’s Formulas
To enable us to analyze a financial statement ratio, we for sure need a set of financial statement. And here are “Income Statement” and “Balance Sheet” of Royal Bali Cemerlang for the year 2003 and 2004 as data source we are going to use through this main topic.
The Income Statement
The income statement is a fairly simple document that begins by listing a firm’s revenues (perhaps by sources or in total) followed by all of the firm’s expenses. The result of the income statement is the net income for the period.
Net income represents the accounting profit left over after all expenses have been paid from the revenue for the period, and below is the Royal Bali Cemerlang’s Income Statement for the year of 2003 and 2004:
The Balance Sheet
The balance sheet is usually divided in two sections: the assets section at the top or left side, and the liabilities and owner’s equity section at the bottom or right side. It is important to realize that the balance sheet must balance (thus the name). That is, total assets must equal the sum of total liabilities and total owner’s equity. Each of these sections is usually further divided into subsections.
On the asset side, there are two subsections. The current assets section describes the value of the firm’s short-term assets. Short-term, in this case, is defined as one year or the time it takes for the asset to go through one cash flow cycle (i.e., from purchase to sale to collection). Typical current assets are: cash, accounts receivable, and inventories. Fixed assets are those assets with lives longer than one year. Examples of fixed assets include vehicles, property, buildings, etc.
Like assets, liabilities can be subdivided into two sections. Current liabilities are those liabilities that are expected to be retired within one year. Examples are items such as accounts payable, wages payable, etc. Long-term liabilities are those that will not be paid off within the current year. Generally, long-term liabilities are made up of various types of bonds, bank loans, etc.
Owner’s equity represents the difference between the value of the total assets and liabilities of the firm. This part of the balance sheet is subdivided into contributed capital and retained earnings. Contributed capital Bali Cemerlang is the investment made by the common and preferred stockholders of the firm. Retained earning is the accumulation of the undistributed profits of the firm. And below is the Royal Bali Cemerlang’s Balance Sheet for 2003 and 2004: