RATIO ANALYSIS
Ratio Analysis is a technique used for financial analysis in which the figures are converted according to the ratios allotted for some useful assessment in comparison with the ratios of the past years and setting a bench-mark for the future years. This technique is very useful so as to establish the trends and bring in light, the strengths and weaknesses of the firm.
The ratio analysis includes ratios that which are made up from the financial statements of the firm and includes key factors like profitability ratio, return on capital employed, liquidity ratios, working capital management ratios and capital structure ratios along with the stock market ratios.
The health of any company is clearly visible in the ratio analysis and gives the interpreter a clear picture when it is compared with the performances of previous years and other similar industry competitors. (Droms W.G., 2003)
RELEVANCE OF RATIO ANALYSIS:
This technique is highly beneficial in assessing the financial health, profitability and operational efficiency of the firm. It ensures that the weaknesses of any firm will not go unnoticed as each and every fine detail is mentioned in the statements which will again be reflected in the ratios found out.
This technique is essential so as to compare the returns of the concerned firm with the industry standards and other leaders of the industry. Its different ratios eases out the job as if any gap found in the performance standards would not go unnoticed.
The data's mentioned in the financial statements are useless unless they are interpreted and worked upon. This technique makes it easy to interpret the financial results and the reasons for such outcomes.
This technique is used by the firms so as to know about the financial health of the firm in regards with the improvement or deterioration. It helps in setting out the direction of a company's action as the output is right out in front.
The accounting ratios of this technique give out the data which is studied, analyzed and worked on. This helps out in setting a budget for gaining the future desired position of the firm.
This technique is also widely used for its relevance in determining the financial health of the company down the line after few years due to various ratios like leverage and capital structure ratios.
(Steffy W., Zearley T., Strunk J., 2007)
Weakness of ratio analysis:
(Brigham E.F., Houston J.F., 2007)
The financial statements given of MG Fabrications include Profit and Loss statements and Balance Sheet.
Profitability ratios:
This ratio basically tells the analyst whether the business is making profit or is at some loss. It also lets the management know whether their strategy has been successful, if any related to the increase of profit margin. These ratios generally represent the sales of the company in relation to the sale of each pound worth of the service.
These ratios indicate the capacity of the company to generate profit or to control its business. The firm has seen the gross profit ratio and net profit ratio decline from 2008 to 2010. This has been primarily due to the fact that the firm has seen the sales figure increasing and not so great increment in profit share in it which might be possible due to the poor management of the funds or assets of the company. Although, the company has increased the sales figures but it hasn't been able to trim the costs down accordingly.
Share-holder's ROCE: (Profit/Shareholder's fund)*100%
For 2008 = (31392.36/46215.25)*100
= 67.92 %
For 2009 = (43164.5/92640.79)*100
= 46.59 %
For 2010 = (53454.35/150838.46)*100
= 35.44 %
Overall ROCE: (Profit/ (Shareholder's fund + Borrowed Capital))*100 %
For 2008 = (31392.36/46215.25)*100
= 67.92 %
For 2009 = (43164.5/92640.79)*100
= 46.59 %
For 2010 = (53454.35/ (150838.46 + 14822.87))*100
= 32.26 %
This ratio tells us the efficiency of the management in utilising the resources made available to them before investing the returns somewhere else. The firm has been experiencing a drastic drop in the return on capital employed i.e. in 2008, the firm was generating 68p for £1 investment, but in 2010, it was generating 36p for £1. This has happened primarily due to drop in the increasing rate of profit and huge increments in sales happening.
Liquidity ratios:
Liquidity imitates any firm's ability to meet the short term obligations against the assets owned by the company which are readily convertible into cash. Current assets are mentioned as working capital as this is the capital which is used in day to day expenditure of the company.
Current ratio: (Current assets/ Current liability)
For 2008 = (44584.73/11561.84)
= 3.86
For 2009 = (100200.45/21344.94)
= 4.69
For 2010 = (180632.43/29942.21)
= 6.03
This ratio indicates the capacity of the firm to pay off its debts within the time frame of a year with current assets in hand. The industry standard is considered to be 2:1. In our case, the company has been experiencing a sharp increase in this ratio. This has happened due to the fact that the company is keeping most of the money from the profits or sales in banks and are not investing it into the business. Also, accounts receivable and inventory in hand has seen a sharp increase.
Quick ratio: ((Current assets - stocks)/ Current liability)
For 2008 = (40879.01/11561.84)
= 3.53
For 2009 = (92789.01/21344.94)
= 4.35
For 2010 = (165809.56/29942.21)
= 5.54
This ratio emphasizes on the fact that not all assets are easily and instantly convertible into cash including the likes of stocks which takes quite some time to be converted into cash as it can only be cashed when it is ready into the final product. The industry standard figure is 1:1. In our firm, it has increase a sharp increase in the ratio from 2008 to 2010. This is also due to the same reason for keeping most of the cash in the bank and not investing it into business.
Working Capital Management:
This ratio basically emphasizes on how well the assets or services of the company are being utilised. This would gauge a firm's capability to use the credit it receives from the market and in turn receive the investment from the debtors as quickly as possible.
Stock Holding Period: (Average stocks/cost of sales)*365
For 2008 = (3705.72/251138.95)*365
= ~ 6 days
For 2009 = (7411.44/412024.84)*365
= ~ 7 days
For 2010 = (14822.87/580758.82)*365
= ~ 10 days
This ratio tells the analyst about the time frame that the firm has to keep the stocks with them before they are sold into the market. This ratio is increasing from 6 to 10 days in the end which is not a matter of concern. But, it should be kept a close eye upon before it goes worse.
Debtors Collection period: (Debtors/ Total Sales)*365
For 2008 = (7411.44/313923.68)*365
= ~ 9 days
For 2009 = (15564.02/494429.8)*365
= ~ 12 days
For 2010 = (35574.9/682784.01)*365
= ~ 20 days
This ratio tells us the capability of the firm to collect money from its debtors as not all business transactions are done in cash. This number should be kept at bare minimum so that the firm receives the capital as soon as possible to be invested again in the business. But, here we see that the time frame has increased more than double for collection which is not a good sign and the company should follow up closely with the clients and put a bit of pressure on them in the permissible limit.
Creditor's payment period: (Creditors/cost of sales)*365
For 2008 = (8300.81/251138.95)*365
= ~ 13 days
For 2009 = (16601.62/412024.84)*365
= ~ 15 days
For 2010 = (24605.97/580758.82)*365
= ~ 16 days
This ratio tells us the time frame that the company takes before handing out the payments back to the creditors. The time frame has been increasing from 2008 to 2010. This is a good sign as this means that the money which is handed out late to the client can help the firm in any investment for that period or to earn interest on it.
Capital Structure ratios:
Financing of a company is done either by equity or debt. Equity allows the director's of the company to decide at their own discretionary and they are not to serve any obligation to anyone apart from its share-holders. But, debt financing involves an element of greater risk and an obligation to pay off the investment along with the interest to the concerned institution or investor.
Gearing ratio: (Borrowed Capital/ (Shareholder's fund + Borrowed capital))*100
For 2010 = (14822.87(14822.87 + 150838.46))
= 8.95 %
This ratio is not applicable for 2008 and 2009 as the company was all financed by equity capital and was not using any borrowed capital or long term loan. But, in 2010, the firm borrowed capital from the market which is a good sign as it helps the company in reducing the taxes as the interest paid for loan is included after deduction of interest.
Interest cover: (Net Profit/ Interest)
For 2010 = (53454.35/ 1482.29)
= 36 times
Since the company had no borrowed money in 2008 and 2009, thus it was not entitled to pay any interest. But, after borrowing money in 2010, it was clearly visible that the company had more than enough funds to cover the interest to be given to the concerned institution or investor investing in the firm.
Dividend Cover: (Net Profit/ Dividends)
For 2008 = (31392.36/3261.03)
= 9.62 times
For 2009 = (43164.5/4743.32)
= 9.1 times
For 2010 = (53454.35/5336.24)
= 10.02 times
This ratio indicates the capacity of the firm to cover the expected or announced dividends of the company for the share holders. The company is in a strong position to pay out the dividends to its share holder's which would further instil confidence in the investors to invest more.
CONCLUSION:
After analysing through the reports of the company and glancing through the ratios, we come to the conclusion that the company is in desperate need of proper management which can take suitable actions. These actions include primarily increasing the gearing ratio of the firm which look's very low. This would in-turn solve most of the problems by saving the money from going into the tax and diverting it as interest.
Another key suggestion might be to decrease the money in the bank and invest it into the company, so that the company can experience greater growth rates and an increased opportunity for the investors as well.
The firm should also keep a close eye on the debtor's collection period ratio as the time has more than doubled within 3 years which is not a good sign.
Reference:
1) Brigham E.F., Houston J.F., Fundamentals of Financial management, 5th edition, Cengage learning
2) Droms W.G., Finance and accounting for non financial managers: all the basics you need to know, 5th edition, Illustrated, Perseus publication
3) Steffy W., Zearley T., Strunk J., Financial ratio analysis: an effective management tool, University of Massachusetts, 2007
All the formulas have been taken from the book by Droms W.G. which is Finance and accounting for non financial managers: all the basics you need to know
