Historically, much of the interpretation of a company's financial position has been based on ratio analysis. Accounting ratios condense the data in a company's accounts and relate different items of data to each other, so that pictures of the company's financial affairs expressed in just a few key numbers can be compared.
Ratios can be interpreted in one of three ways:
1. A company's actual ratios achieved can be compared with an acceptable or safe norm.
2. A company's ratios in the current and most recent years can be compared with the same ratios it achieved in earlier years, to detect an improving or declining trend, so-called horizontal analysis.
3. A company's ratios can be compared with similar ratios for other companies of a similar type in the same industry, so-called cross-industry analysis.
Ratio analysis can help to indicate whether a company's situation is getting better or worse, or is staying much the same. Ratios can also help to indicate areas of weakness in a company's financial performance.
Ratios by themselves are of little use. The key to obtaining meaningful information from ratio analysis is comparison-comparing ratios over time with the same business to establish how things are changing, or comparison with similar businesses to see whether the company is better or worse than average within a particular sector. However, each business should be considered separately, as a ratio that is meaningful for one type of company, (a construction company) may be completely misleading if compared with another type of company. The key to ratio analysis lies in understanding what the purpose of the analysis is and continually returning to this reference point.
It is also important to appreciate that ratios can provide useful information, but they are unlikely to be completely accurate or tell the whole story.
Different types of financial ratios can be used for different purposes:
• Activity analysis considers the trend in sales and an upward trend could indicate expansion or may be a result of inflation. Any downward trend could be the result of such factors as business rationalisation, deflation, a lack of competitiveness, technical obsolescence or marketing problems.
• Liquidity ratios are used as a measure of cash flow, or having sufficient cash to meet short-term commitments. They therefore refer to the amount of assets held in cash or near cash, usually in relation to the size of debts payable in the near future. There is no ideal level for these ratios, although it is generally considered that the range 1.5 to 2.0 for the current ratio and 0.8 to 1.0 for the quick ratio represents a good standard.
• Long-term debt and solvency ratios can be used to assess a company's capital structure. A high proportion of debt capital could indicate that the company is at some financial risk.
• Profitability analysis and valuation ratios typically relate to the performance of the company and are usually of most interest to shareholders, who naturally want to know how well their investments are doing.
The table below contains some example of the types of financial ratios typically used to monitor the financial performance of company.
Table F.1: Monitoring company performance - typical financial ratios
Type | Ratio | Calculation | Explanation |
Activity analysis | Receivables turnover | Sales/average trade receivables | Measures the effectiveness of the firm's credit policies |
Liquidity analysis | Current ratio | Current assets/current liabilities | Measures cash resources with cash obligations |
Quick ratio | (Current assets - stock)/current liabilities | Excludes inventory from cash resources | |
Defensive interval | 365 x ((current assets - Stock)/operating cash flow) | Indicates the number of days the firm could maintain the current level of operations with its present cash resources | |
Long-term debt and solvency analysis | Debt to equity | Total debt / total equity | Examines a firm's capital structure and, indirectly, its ability to meet current debt obligations |
Times interest earned | Earnings before interest and Taxes/interest expense | Measures the extent to which earnings available for interest 'cover' interest expense | |
Profitability analysis | Return on assets | (Net income + after-tax interest cost)/average total assets | Return on assets indicates how capital-intensive a company is, that is how much income is the company generating given the amount of assets |
Return on equity | Pre-tax income/average stockholders' equity | Return on equity measures the rate of return on shareholders' investment | |
Valuation | Earnings per share | Earnings available to common shareholders/ Weighted-average number of shares of common stock outstanding | This is the amount of profit on ordinary activities after tax and preference dividends expressed on a share basis |
| Dividend payout ratio | Dividends/Net income | Percentage of earnings paid out as dividends |
| P/E ratio | Current mid-market price/earnings per share | Market price of shares as a multiple of the earnings per share |
The commercial adviser for each specific project can advise on the most appropriate ratio and range for that type of project.