Interpretation of Financial Ratio

8/8/2019 Interpretation of Financial Ratio

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Interpretation of Financial Ratio:

Creditors need to know about a companys liabilities and profits to determine whether to make

additional loans.

Owners, creditors, and other decision makers can examine return on assets for XCompany to decide whether the company is earning a reasonable profit.

The statement of cash flows, which is a more recent addition to external reports, provides

information that enables creditors, investors, and other users to assess a company's ability to

meet its cash requirements.

Sometimes comparisons are made among companies.Comparisons are also made among different divisions of acompany. For example, a decision maker maybe interested inhow the East division of a company compares with the West

division, or how the U.S. division compares with the Europeandivision. Or comparison of the same company at a differentfinancial periods

Gross profit is a measure of how much a company earned directly from the sale of itsproducts during a finacial period.

Every company would like to earn a large gross profitby selling its products at a much

higher price than their cost. Competition prevents most companies from being able to do so.

Companies must price their products at amounts their customers are willing to pay, which is

determined in part by prices of other similar products that customers could buy from other

companies. Any Company cannot sell its products at a price that is much higher than that of

other companies that sell similar products. Therefore, Companies have to purchase the

goods it sells at a cost that allows it to earn a reasonable gross profit.

The amount of gross profit a company can earn depends on the kinds ofproducts itsells and the markets in which it operates. Some markets are more competitive thanothers. Forexample, many competing companies sell computers, but not many sell theoperating systems for computers.

Profit Margin (or return on sales) is the ratio of operating profit

to sales.Profit Margin (or Return on Sales) = Operating profit Revenues

It is a measure of the ability of a company to produce profits from itssales.

A company with a high protit margin is more efficient in controlling costs


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than one with a low protit margin.

We can translate profit margin into dollars. Krispy Kremes profit margin of4.9% in 2001 Means that the company was able To generate 4.9 of netincome(operating profit) for every $ 1 of sales.

The second section of an income statement lists operating expenses otherthan cost of goods sold or cost of services sold.

Operating expenses are costs of resources consumed as part of operating

activities during a fiscal period and that are not directly associated with

specific goods or services.

Operating expenses include selling, general, and administrative expenses

incurred during a period.

Corporations usually do not identify specific operating expenses in detail.

Salaries for managers and their support staffs who are not involved directly in

producing goods and the cost of resources used by managers are operatingexpenses.

These expenses include depreciation. taxes, and insurance on office buildings

and equipment, and the costs of supplies and utilities consumed in operating

these facilities.

Operating expenses also include marketing and product development costs.

GAAP required most marketing and selling costs and research anddevelopment costs incurred during a fiscal period to be reported as operating

expenses of the period in which they occur.

Because identifying how much of these costs is associated with benefits offuture periods is difficult,


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GAAP require that these amounts be expensed to avoid an overstatement of

profits during the current fiscal period.

The excess of gross profit over operating expenses is operatingincome. If operating expenses are greater than gross profit, a loss fromoperations results. Operating Income is a measure of how much acompany earned from its basic business activities (orbusinss primaryoperatings.Basic operating activities are selling process, marketing, & research anddevelopment activities.

A company is in the business of acquiring and selling products. Cost ofgoods sold and other operating expenses include the cost ofacquiring andmaking its products available to customers. Sales revenues, sometimes

referred to as operating revenues, are the total prices of the goods soldduring a financial period. Therefore, operating income is a measure of howmuch a company made from selling its products, after considering normaland reoccurring expenses of doing business.

A common analytical tool involves the calculation of ratios.

Most ratios compare one financial statement number with another.

One example is return on assets.

Return on assets (ROA) or Return On Capital Employed (ROCE)is the ratio of Operating profit to total assets.

A Common measure of the outcome of a companys investment decisionsis return on assets (ROA).

Because total assets are equal to the total investment in a company fromcreditors and owners, return on assets measures return on total investment

in a company. We can calculate return on assets for X Company at as:Operating ProfitReturn on Assets = Net Assets

We can interpret the ratio as the amount a company earned for eachmoney unit (e.x. Saudi Riyal) of total investment.


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If Company X has higher RONA Ratio than Company Y this is meanCompan X was creating a higher return on its investment inassets than compan Y.

This ratio is a good return or not can be assessed by comparing the

amount

with expectations of owners,

with returns for similar companies, and

with returns for other periods

A good return for one company is not necessarily good for another,

particularly if the companies operate in different industries, countries, orgeographic regions.

Owners, creditors, and other decision makers can examine return onassets for the company to decide whether the company is earning areasonable profitIf the return is not satisfactory, Managers can make changes in the

business.

Efficiency:

Asset turnover It is a measure of the ability of a company touse its assets to sell its products.

Asset turnoveris the ratio of revenues to total assets:Asset Turnover = Revenues Total Assets

Additional investment and asset growth are valuable when a company usesthese assets to generate higher profits.A company with a high asset turnover is more effective in using its assetsthan one with a low asset turnover.

Kremes Asset turnover of 1.75 in 2001 means that the company was ableto generate $ 1.75 of sales for every $ 1 It had invested in assets.

Asset turnover also increases when a company sells products in highdemand.If Starbucks has products in its stores that customers are not


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willing to buy, its sales will be low relative to the amount ithas invested in assets. If it replaces these products withothers that customers are in terested in buying, its assetturnover will increase.

Also, it can increase asset turnover by closing locations that do not createhigh sales and moving its assets to locations that produce higher sales.

Sometimes, no additional investment was made to create the additionalincrease in sales.Company management found a better way to use the companys assets.

One way to examine events that affect a companys return on assets(ROA)

is to separate return on assets into components.Two primary components of ROA are asset turnover and profit margin(=Netmargin = Net Profit margin).ROA = Net Margin X Asset Turnover

Profitability depends on the ability of a company to use its assetsto sell products (Asset turnover) and on the ability of a companyto earn a profit from those sales (Net Margin). Krispy Kreme Wasdoing a relatively good job of selling its products but was not

earning as much profit on those sales as Starbucks (in the belowcase).

Return onequity (ROE)or Return on Investment (ROI) is Profitafter tax divided by stockholders equity.

It measures net income relative to the amount invested by stockholders in acompany, including retained earnings.

Investors and financial analysts use return on equity to compare the

performances of Companies, either

to compare one company with another or

to compare a companys performance in one period with itsperformance in another period.


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Working Capital:

Working capital is the difference between current assets and currentliabilities

Because current assets include those assets that are likely to produce cashinflows for a company and current liabilities include those liabilities that arelikely to produce cash outflows, working capital is a measure of acompanys liquidity.

A company with a large amount of working capital should have little(CASH) difficulty meeting its short-term obligations. Working capital often isreported as a ratio.

Working capital often is reported as a ratio.

The ratio of current assets to current liabilities is the working capital ratio or

current ratio.

A commonly used liquidity measure is the current ratio.

Current ratio:current assets divided by current liabilities.

If this ratio is low, especially if it is less than one, or if it decreasessubstantially over time, the risk that a company may not be able to pay itscurrent liabilities or obligations increases.

Compan X with higher Current Ratio than Company Y means: that CompanX was in a better position to meet its current liability obligations thanCompany Y.


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Gearing Ratio:

It used in evaluating the ability of each company to make debt and interest

payments. Creditors and stockholders are concerned about a companys ability to

meet its obligations, including the payment of interest, as they become due.

Debt ratios, such as the ratio of debt to total assets, provide information that is

helpful in evaluating default risk.

Defa tilt risk is the likelihood that a company will not be able to make debt or

interest payments when they come due. As the amount of debt in a companys

capital structure increases, the likelihood of default increases because principal and

interest payments become larger.

Therefore, though financial leverage can increase a companys return on equity, the

amount of financial leverage a company can use is limited by the amount of

principal and interest the company can pay and still have enough cash to cover

expenses, purchase new assets, and pay dividends.

Also, as financial leverage increases, the interest rate demanded by creditors is

likely to increase. Creditors demand higher returns as compensation for the higher

default risk of a companys debt.

Creditors may impose limitations on a companys ability to borrow additional

money. require it to maintain a certain debt ratio, or limit its ability to pay dividends

unless certain ratios are maintained.

These limitations Are called debtcovenants , and they protect the interests of

Creditors against a company becoming too risky or paying cash to stockholders when ithas too much debt.

Documents

Interpretation of Financial Ratio