Usefulness and Limitations of Financial Ratios - Essay Example

Usefulness and limitations of financial ratios Usefulness and limitations of financial ratios Financial ratios help in expressing the relationship between the items on financial statements for a given entity. Despite the fact that most of the financial statements provide historical data, management and other users of financial information can use the ratios to identify strengths and weaknesses within the entity as well as help predict future financial performance. Investors use these ratios to make comparisons between companies in the same industry. Most of these ratios are not generally meaningful when evaluated alone but they tend to bring meaning when they are compared to historical information and industry averages (Watson, Shrives & Marston 2002, p. 300). Ratios can be sub-divided into four major classes: Liquidity ratios Profitability ratios Operational efficiency ratios Leverage ratios Liquidity ratios This class comprises of current ratio, quick ratio and working capital ratio. The most common ratio is the current ratio/working capital ratio which represents the ratio of current assets to current assets. This ratio shows the company’s capability to meet its short term bills and expenses. Current ratio which is greater than one is more preferred since it means that the company has more current assets than current liabilities. A ratio which is less than one is unfavorable because it means that the company has more current liabilities than assets (Whittington 1980, p. 222). A high current ratio indicates a safety cushion and increases the flexibility since some of the stock items and receivables in arrears may not be easily be converted into cash. Entities can improve current ratio by the conversion of short term debts into long term debt, collecting promptly its receivables, buying inventory when only needed and necessary and paying down all debt. Current ratio is given by: Current Assets Current Liabilities Quick ratio is gives as below: Cash + Marketable Securities Current Liabilities This ratio is often termed as a more stringent liquidity test as it indicates whether a firm has adequate short-term assets to cover for current liabilities and this excludes selling inventory. A ratio of 1:1 shows that that an entity can pay its expenses without being forced to sell inventory (Barnes 1987, p.484). Working capital is a measure of cash flow and for an entity to be running well, this ratio must always be positive. This ratio measures the amount of that has been invested in resources subject to quick turn over. In most cases, lenders use this ratio to evaluate and ascertain the ability of the company at hard times (Whittington 1980, p. 219). It is given as Current assets minus current liabilities. In the financial year 2013, easy jet plc had the following liquidity ratios namely, current ratio of 0.89, quick ratio of 0.89 and a cash ratio of 0.75. All these ratios were positive thus favorable for the entity. One major limitation of the liquidity ratios is that they do not focus much on the quality of the current assets in use. For instance, the current ratio does not give accurate information on the entity’s liquidity as it may be in trouble because of the more inventories that can easily be converted into cash within a very small period of time. Valuation of currents assets is also a major issue when calculating the current ratio (Barnes 1987, p.459). Operational efficiency ratios These ratios are used compare performance of an entity over multiple periods. They show how effectively and efficiently a company is utilizing their assets and managing their liabilities. They include: Operating expense ratio This ratio helps compare expenses and revenues. A decreasing ratio is more favorable because it indicates an increased efficiency. This ratio is give by the formula, Operating Expenses Total Revenue. Accounts receivable turnover Represents the number of times in which trade receivables turn over during the given financial year. Higher ratio means that there is a very short time between credit sales and cash collection. This ratio is give as Net Sales Average Accounts Receivable Total assets turn over This ratio represents how efficiently an entity generates sales on each denomination of an asset. Given as Revenue Average Total Assets Fixed assets turnover An increasing fixed assets turnover ratio indicates that an entity is using their fixed assets more productively (Watson, Shrives & Marston 2002, p. 289). It’s given as Revenue Average Fixed Assets In the financial year 2013, easy jet plc had the following liquidity ratios, receivables turnover of 37.73, and a total assets turnover of 1.02, which were relatively desirable for the entity. Profitability sustainability ratios These ratios show how well the entity is performing over a given period of time. They look at whether the entity has enough financial resources to continually serve the interests of the stakeholders and lenders (Gibson 1987, p.75). Sales growth-this represents the percentage increase or decrease in sales generated between two periods of time. This ratio helps to compare sales and other overall costs of the entity as well as the levels of inflation. Increased costs and inflation should lead to corresponding increase in sales. It is given as Current Period –Previous Period Sales Previous Period Sales Gross profit margin This indicates the profits earned on products and services offered without considering other indirect costs. Small changes in gross margin could lead to significant effects on the profitability (Barnes 1987, p.451). . It is given as Gross Profit Total Sales Total Sales Return on capital Return on capital represents a measure of how efficiently and effectively an entity employs its resources so as to generate profits. When the resources are put together, they represent the tangible statistics behind the strategy of purchasing good business (high return on capital) at relatively low prices (high earnings yield) (Watson, Shrives & Marston 2002, p. 296). There are several ways of measuring Return on capital. The most well known and most widely used return on capital ratios are Return on assets (ROA) and return on equity (ROE). Return on assets equation helps in measuring the profits earned on assets such as buildings, equipment, cash, inventory and so forth (Gibson 1987, p.76). ROA is calculated as: ROA = Net Income / Total Assets On the other hand, Return on equity represents the profit earned on each figure of equity capital. In other words, every dollar owned by the company. This is more realistic and meaningful because it puts into accounts an entity’s debt and liabilities and helps give a better estimate of what exactly is net capital (Whittington 1980, p. 243). ROE is calculated as follows: Return on equity = Net Income / Total Equity These measures are not without limitations. Return on assets is mostly applied and becomes useful only when comparing firms and entities that belong to the same industry. It is usually not useful when comparing entities from different industries with varying capital requirements. Moreover, ROA does not take into consideration the assets which are actually employed when generating profits and which profits are extra. Return on equity is somehow better than the return on assets since it subtracts out liabilities. However, it is believed that ROA can present a skewed picture for the entities with large amounts of debt (Horrigan 1965, p. 560). In the financial year 2013, Easy Jet delivered a profit before tax of £478 million which represented a £161 million increase from 2012. This represented a profit before tax margin of 11.2 per cent. Return on Capital was 17.4 per cent which represented a 6.1 per cent increase from 2012. Operating cash for the year 2013 was at £616 million. This was one of the strongest financial performances of the company and could be contributed to the cash generated during the year and the strength and robustness of the company’s balance sheet. Return on assets was at 10.10, return on equity at 21.48, and return on invested capital at 17.13. Leverage ratios These ratios help to measure the degree to which an entity utilizes borrowed funds as well as analyzing the level of risks. Lenders and other stakeholders often use this ratio information to evaluate a company’s ability to repay debt (Gibson 1987, p.74). These ratios include Debt to equity This helps in comparing the capital invested by shareholders and the funds obtained from lenders. Lenders are given priority to capital investors when it comes to the entity’s assets. Lenders want to see that there is some degree of going concern in case of financial difficulties. Too much borrowed capital could put an entity at risk (Fraser 2013, p. 374). This ratio is given by the formula Short Term Debt + Long Term Debt Total Equity (including grants) Interest coverage This helps in measuring the ability to meet the obligations of interest payments with the entity’s income. Interest coverage ratios of less than 1 mean that the entity is experiencing difficulties in generating cash flow to pay interest. A ratio of above 1.5 is ideal and desirable (Horrigan 1965, p. 559). It is given by EBITDA Interest Expense Consider the following statistics from easy jet plc financial statements in year 2013. Total debt to total equity was 25.92, total debt to total assets was 12.54, and total long term debt to equity was 21.73. Different accounting assumptions may make it hard to make comparisons for the ratios from different organizations or entities. These assumptions may include LIFO, FIFO and the different methods of calculating depreciation such as the straight line method and the double declining balance (Barnes 1987, p.461). Bibliography Barnes, P. 1986. "The statistical validity of the ratio method in financial analysis: an empirical examination: a comment", Journal of Business Finance and Accounting 13/4, 627-635. Barnes, P. 1987. The analysis and use of financial ratios: A review article, Journal of Business Finance & Accounting, 14(4), Winter, pp. 449-461. Cowen, S.S., and Hoffer, J.A. 1982. "Usefulness of financial ratios in a single industry", Journal of Business Research 10/1, 103-118. Foster, G. 1978. Financial Statement Analysis. Prentice-Hall, first ed. Fraser, Lyn M 2013. Understanding financial statements, 10th Edition, International Edition, Boston, MA : Pearson, 304 Gibson, Charles 1987. How Chartered Financial Analysts View Financial Ratios, Financial Analysts Journal / May-June, pp.74-76. Horrigan, James O. 1968. A Short History of Financial Ratio Analysis, The Accounting Review, Vol. 43, No. 2 April, pp. 284-294 Watson, A., Shrives, P. & Marston, C. 2002. Voluntary disclosure of accounting ratios in the UK, British Accounting Review, Vol. 34, pp. 289-313 Garcia-Ayuso, M. 1994. "The functional form of financial ratios: further empirical evidence", paper presented at the XVII annual meeting of the European Accounting Association, April 1994, Venice. Horrigan, J.O. 1965. "Some empirical bases of financial ratio analysis", Accounting Review, July 1965, 558-568. http://corporate.easyjet.com/~/media/Files/E/Easyjet-Plc-V2/pdf/investors/result-center-investor/annual-report-2013.pdf Whittington, G. 1980. "Some basic properties of accounting ratios", Journal of Business Finance and Accounting 7/2, 219-232. Read More