Ratio analysis

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Commodity Online  Feb 2  Comment 
Ratio analysis shows us how undervalued the smaller gold stocks are yet an examination of history shows this is not out of the ordinary at this point in a bull market
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The gold/silver ratio has just broken in favor of silver. In other words, the ratio has broken to the downside. There are some important points to take away from the gold/silver ratio.




 
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Financial Ratio Analysis is the calculation and comparison of main indicators - ratios which are derived from the information given in a company's financial statements(which must be from similar points in time and preferably audited financial statements and developed in the same manner). It involves methods of calculating and interpreting financial ratios in order to assess a firm's performance and status. This Analysis is primarily designed to meet informational needs of investors, creditors and management. The objective of ratio analysis is the comparative measurement of financial data to facilitate wise investment, credit and managerial decisions. Some examples of analysis, according to the needs to be satisfied, are:

  • Horizontal Analysis - the analysis is based on a year-to-year comparison of a firm's ratios,
  • Vertical Analysis - the comparison of Balance Sheet accounts either using ratios or not, to get useful information and draw useful conclusions, and
  • Cross-sectional Analysis - ratios are used and compared between several firms of the same industry in order to draw conclusions about an entity's profitability and financial performance. Inter-firm Analysis can be categorized under Cross-sectional, as the analysis is done by using some basic ratios of the Industry in which the firm under analysis belongs to (and specifically, the average of all the firms of the industry) as benchmarks or the basis for our firm's overall performance evaluation.

The informational needs and appropriate analytical techniques needed for specific investment and credit decisions are a function of the decision maker’s time horizon(short versus long term investors and creditors). A pervasive problem when comparing a firm’s performance over time(trend or time series analysis) or with other firms(cross sectional or common size analysis) is changes in the firm’s size over time and the different sizes of firms which are being compared. However, one approach to this problem is to use common size statements in which the various components of the financial statements are standardized by expressing them as a percentage of some base (base in the income statement is sales and base in the balance sheet is total assets). See sample file below for further understanding.

In general, a process of standardization is being achieved by the use of ratios. They can be used to standardize financial statements allowing for comparisons over time, industry, sector and cross-sectionally between firms and further facilitate the evaluation of the efficiency of operations and/or the risk of the firm’s operations regarding the scope and purpose of evaluation. Ratios measure a firm’s crucial relationships by relating inputs(costs) with output(benefits) and facilitate comparisons of these relationships over time and across firms.

Many attractive categories of financial ratios and numerous individual ratios have been proposed in the literature. The most prominent literature on financial analysis - though non-exhaustive - indicates the following categories of ratios:

Profitability

or Return on Equity (ROE), in times = Net Income ÷ (Average Equity during the period)

Very often, the reported profits are adjusted to reflect sustainable levels of performance and thus instill more meaning to the computation and interpretation of the financial ratios. In this context, EBITDA is used, which is calculated by excluding from the profit figure the tax, interest, depreciation and amortisation amount. Non-reccuring expenses or income is also excluded when this can be substantiated to enhance the interpretation of the derived ratio figures. EBITDA figure can be used as an approximation of the underlying cash flows which at the same time incorporate the future potentials of the company's profitability rather than just the cash generation of a financial year.

Activity or Management Efficiency ratios

  • Debtors days, in days = ( Av. Debtors / Sales ) * 365
  • Creditors days, in days = ( Av. Creditors / COGS ) * 365, where COGS is the Cost of Goods Sold by the firm
  • Stock days, in days = ( Av. Stock / COGS ) * 365

Where "Av.", is the Average amount of the opening and closing balance of the corresponding account of the financial year the Analysis is being undertaken.

Market or Investment ratios


Each category can be further utilized and an in-depth analysis can be adopted to reflect the corresponding needs of each user, i.e. a bank considering whether to lend a specific company would focus more on financial and liquidity - as the risk of lending to a company that does not have the resources to repay the loan is of great concern for a bank - and profitability ratios, to see whether the company's earnings are adequate to cover the interest on the loan. An analysis from an investor's point of view on the other hand would focus more on profitability and investment ratios, to evaluate the prospects of his potential returns.

Note that there is no absolute guidance or specific definition of ratios and therefore special consideration should be undertaken when ratios are used to make comparison either in a cross-sectional analysis or Inter-firm (as described above).

Limitations of ratios and potential impact in the financial analysis

  • Ratios are not predictive, as they are usually based on historical information notwithstanding ratios can be used as a tool to assist financial analysis.
  • They help to focus attention systematically on important areas and summarise information in an understandable form and assist in identifying trends and relationships (see methods for facilitating the financial analysis above).
  • However they do not reflect the future perspectives of a company, as they ignore future action by management.
  • They can be easily manipulated by window dressing or creative accounting and may be distorted by differences in accounting policies.
  • Inflation should be taken into consideration when a Ratio Analysis is being applied as it can distort comparisons and lead to inappropriate conclusions.
  • Comparisons with industry averages is difficult for a conglomerate firm since it operates in many different market segments.
  • Seasonal factors may distort ratios and thus must be taken into account when making ratios are used for financial analysis.
  • Not always easy to tell that a ratio is good or bad. Must be always used as an additional tool to back up or confirm other financial information gathered.
  • Different operating and accounting practices can distort comparisons.
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