10AC010358 Agunbiade Deborah Oluwatosin

10AC010361 Enueme Florence Chineye

10AC010378 Opufou Joseph Oyinamabra

10AC010379 Orhobor Oghenetejiro

10AC010388 Yakubu Wuraola Halimat

INDUSTRIAL RELATIONS AND HUMAN RESOURCE MANAGEMENT

300 LEVEL

BFN311 TERM PAPER

FINANCIAL RATIO ANALYSIS

 Introduction
 Definitions and uses of financial ratios
 Nature and contents of financial statements
 Users of financial ratios
 Financial ratios
Financial Ratio Analysis

INTRODUCTION

Financial analysis is the selection, evaluation, and interpretation of financial data,

along with other pertinent information to assist in investment and financial
decision making (Peterson Drake).
The role of planning and financial management is an assignment for a manager; it is
a very crucial responsibility of the manager to have the ability of interpreting
financial implications and standings in the firm. Financial analysis gives the various
users the opportunity to take responsible business risk and make proper decisions
with the use of quick ratios. Ratios are the estimations deducted when putting two
financial values together, it is the relation between two similar magnitudes with
respect to the number of times the first value contains the second value
(Dictionary.com). They may be calculated in various dimensions such as times or
percentage.
The use of ratio is to help make meaning of the financial values, that is, it impossible
for a value to make sense of itself if not compared alongside another value that
validates its usefulness. For example, a company may have $5million worth of
assets; however, this value makes no sense until it is compared with the company’s
liabilities, the value of other company’s assets or other financial values.
Therefore, we can deduct that financial ratio analysis is best used to critically
examine the firm using financial data, which would highlight the stability, strengths
and weaknesses of the firm and help make vital decisions or take corrective action.
It is important to note that most of the users have limited access to the fully
detailed financial statements; they will most likely be limited to the published
version of these statements.
Also, the interpretation and analysis of financial statement involves identifying the
users of the statements, examining the information, analyzing an d reporting in a
standard format which will give adequate information for business or economic
decisions.

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Financial Ratio Analysis

What makes a financial ratio applicable?

 The validity of the financial information given; it must be up-to-date, accurate,

correct and reliable.
 Both values must be gathered for the same point in time, that is, the financial values
must be gotten from the same financial year in the organization. This should also
take into consideration of the future or present time values.
 These analysis are best useful when calculated over a cyclical period, therefore it is
possible for managers to ascertain the progress of the organization.
 They should be gainful when trying to compare values with that of other companies
in the same industry.
 It must be carefully interpreted and presented.
 It must be able to help compare the organizational standards; is the firm reaching
its own internal goals?

Why are financial ratios useful?

 It is used to compare results over a period of time

 It is used to measure the organization’s performance against other organizations,
usually in the same industry
 It is used to compare results to internal targets
 It is used to compare against industry targets.

NATURE AND CONTENTS OF FINANCIAL

STATEMENTS

Financial statements were created with the aim of passing as much information
about the financial standing and affairs in the organization.

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Financial Ratio Analysis

There are three basic accounts in the financial statements of any organization;
Balance sheet, profit and loss account and cash flow statement. Both the profit and
loss account and the cash flow statement are commonly addressed as income
statements, because they give a simple overview of how much of the investment of
the company has yielded or multiplied overtime. Basically, with the information
derived by these financial statements, ratios can be deducted and conclusions can
be made.

It is important to note that every organization is responsible and liable for the
information given. It is expected that records should not be falsified or incomplete,
if so, it would be assumed that the organization is curbing relevant information as
every detail of these statements would lead to a ripple effect for any conclusions
made.

A balance sheet it is the resources that the business owns and to the debts and
other obligations in respect of these resources (Soyode, 1988). It is a statement of
the financial standing of an existing business venture at a given period in time.
Assets are resources owned by the organization while liabilities are the items the
company owes. Anything that has current value and financial potential could be
referred to assets. The difference between the monetary value of assets and that of
liabilities is called owner’s equity.

Profit and Loss Account is defined as the account, which shows the results of
operation over a particular accounting period, usually a year. The objective is to
report the magnitude of profit or loss made during the year under review.

Cash flow statement is also referred to as statement of changes in financial position.

It provides information about cash inflows and outflows during the year. It has
three parts namely:

 Cash inflows from operating activities

 Cash inflows from investing activities

 Cash inflows from financing activities

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Financial Ratio Analysis

USERS OF FINANCIAL RATIO

There are two basic categories of financial ratio users:

1. Internal users are:

 Management

These are the employees who have access to this information and ensure the
stability of the affairs in the firm. They have the authority, which may be sometime
s limited from the owners of the company. They can make quick and immediate
decisions when needed. The managers also use this analysis to align their
subordinate as to what should be done to improve the productivity level of the firm.
They can also use it to appraise themselves in terms of how much they have
invested in the business and how much more they need to invest. The managers are
defiantly interested in the survival of the firm as it is their sole duty to ensure that
the firm is properly managed, and they want to get the best out of the company.

 Owner/ shareholders

These are the overall heads of the organization. They are at the top of the
organogram and have the most influence on the operations of the firm. Usually, the
owners are given a quick overview and interpretation of the analysis. The=is helps
them make key decisions in the organization. The owners and shareholders have
most of the equity set up of the organization. Therefore, it is their responsibility to
ensure that their investments yield profit overtime, this is why survival of the firm
is very crucial to these users.

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Financial Ratio Analysis

 Employees/Trade Union

The employees of a firm are concerned the most vital part of any organization,
without the employees the organization will have no ground for participation.
However, why is financial analysis useful to them?

An employee needs to feel secure enough to perform his duties productively; if an

employee is uncomfortable with the financial state of the organization, it is most
likely for employees to engage in the act of soldiering which may be as a result of
fear of job loss or fear of not being well compensated. Therefore, the employees
need to be informed about the financial stability of the firm to help them input
more into the organization, so as to help them receive much more from the
organization.

By safety of the employees in check, the employers do not need to worry about any
disturbance from the platform of trade unions. Once trade unions are aware of the
ability of the firm to properly attend to their employee needs, there is little or no
demand on the employer or organization.

2. External Users are:

 Creditors

These are the indebtedness of the firm, that is, the money they owe to people. These
people are interested in the financial stability of the firm because they simply want
to be paid back as soon as possible. There is a possibility that the investments of the
creditors may not be retrieved if the company goes bankrupt, this is why the
creditors try to monitor the firm’s financial status and ensure that the firm when
able pays back what is owed.

 Custom and Exercise

These are bodies that simply store records and are obliged to have information
about the financial status of companies. The information may or may not to directly

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Financial Ratio Analysis

relevant to them, but must be routinely observed. They may also be bodies of the
government who intend on sanctioning and correcting any deviation from
members of the firm.

 Competitors

These are other organizations in the industry that usually have influence on the
decisions of each other. Competitors need to know how well other firms are
performing because they need to level up there standard and if necessary create
strategies that will help defeat their market rivals. Every organization is always
looking for ways to survive and present their best components to help them remain
market leaders. This gives the company an edge in many ways. By knowing the
status of the competitors, firms may decide to tackle against or learn from each
other, this creates a health competition in the market and definitely would benefit
the consumers.

 Researchers

These are people who simply collect financial information for collation, record
keeping or hypothesis testing purposes. They are usually not interested in the
performance of the organization as the stand to lose or gain anything. Researcher’s
interest is to ascertain facts in the quest for intellectual development. They can also use the
information obtained to carry out trend or industry analysis, thereby providing a sound
framework for policy formulation.

 Banks

Banks are interested in the financial ratios of an organization because lending

options are determined by the liquidity and performance of the organization. It is
the duty of the banks to ensure that their investments do not turn into bad debts
but rather on the long run would multiple into profits and interests.

 Tax authority

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Financial Ratio Analysis

These are the bodies that determine the amount of tax that would be paid by the
firm. That is, the percentage rate of the financial quality of the firm to which tax is
paid. The better the performance of a firm, the higher the rate of the tax paid.

 Press

This is the platform of the mass media to expose the financial details of the
organization. It is one of the most commonly used ways to reveal the progress of
the firm, although many organizations tend to falsify information, the information is
expected to be trust worthy and of actual value.

FINANCIAL RATIOS

1. Short Term Solvency and Liquidity Ratios

These ratios provide information on whether or not the company is able to
reach their short term obligations to the users of the information. It measures
the ability of the firm to pay debt in cash.

i. Current ratio

This measures the ability of the firm to meet short term obligations with
short term assets; it is also a useful indication of cash flow in the near
future. It may also be referred to as working capital.
Effective management of working ensures that the organization is
running efficiently, this will eventually lead to increased profitability
and positive cash flow.

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Financial Ratio Analysis

The average current ratio is usually around 2:1, but this may vary with
different industries. Low current ratio may indicate insolvency. High
ratio may indicate not maximizing the returns on working capital.

ii. Quick ratio (acid test)

iii. Debtors turnover

Debtors
Annual Credit sales

iv. Debtors collection period

Average trade debtors x 360
Credit sales

v. Creditors payment period

Creditors x 360
Purchase

vi. Stock turnover ratio

Cost of goods sold
Average stock

Average Stock = Opening stock + Closing stock

2

vii. Number of days stock in store

Average stock
Cost of goods sold

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Financial Ratio Analysis

2. Long Term Solvency and Stability Ratios

i. Gearing ratio
Gearing is the relationship between debt and equity. Debt is usually a
long term liability that the organization has. Equity is all the share capital
and reserves. Gearing is one of the most widely used terms in
accounting; it calculates how much of the total capital is in the form of
equity or debt. Gearing is relevant to the long term financial stability of
the firm.
Fixed Interest Loans + Preference Share Capital
Ordinary share capital + Reserves

ii. Fixed interest cover ratio

Profit before Interest and Taxes
Fixed Interest

iii. Long term to shareholders’ funds

Long Term Debt
Shareholder funds

iv. Total debts to shareholders’ funds

Total External Liabilities
Shareholders’ Funds

3. Efficiency / Profitability Ratios

i. Return on capital employed (ROCE)

This measures profitability and shows how well the business is utilizing
its capital to generate profits. Capital employed is debt and equity. Equity
is shareholders funds and debt is noncurrent liabilities. It is calculated in
percentage. A low rate of return on capital employed could be caused by

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Financial Ratio Analysis

either a low profit margin or a high capital employed. A high rate of

capital employed is either caused by high profit margins or low capital
employed. It is therefore very crucial to assess the profitability, assets,
liabilities and share capital when giving reasons for changes in ROCE.

ii. Return on shareholders’ equity

This calculates the rate of return on investments by shareholders. This is

one of the most important ratios to investors.

iii. Gross profit margin

This calculates how much profit is earned on the company’s products

without considering indirect costs. Small changes in gross margin can
significantly affect profitability.

iv. Net profit margin

v. Capital employed turnover

Sales
Capital employed

vi. Expense to sales ratio

Individual expense x 100
Sales

vii. Total assets turnover

Sales
Total assets

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Financial Ratio Analysis

viii. Individual assets turnover

Sales
Individual assets

ix. Return on sales

This is the difference between operating revenues and operating expenses.

4. Investors Stock and Market Ratios

i. Earnings per share

This ratio shows the profitability of each share, that is, the amount of
available dividend per share. This ratio is very vital and is expected to be
published in the yearly public accounts of the firm.

ii. Price/Earnings ratio

This ratio is the most commonly used among investors; it shows the
market confidence in the company by using the current market price, in
relation to the most recent earnings per share. A high price/earnings
ratio indicates good growth prospects.

iii. Earning yield

EPS x 100
Market price per ordinary shares

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Financial Ratio Analysis

iv. Dividend per share

Gross dividend x 100
No. of ordinary shares in issue ranking for dividend

v. Dividend payout ratio

Dividend per share x 100

Earnings per share

vi. Dividend yield

This is the cash returns on shares. The higher the share price, the lower
the dividends yield.

vii. Dividend cover

This shows the safety of the dividend payments. That is, the amount of
times the dividend value can be paid with the current profit earned.

viii. Net assets per share

Net assets – preference share capital
No. of ordinary shares ranking for dividend

ix. Price cash ratio

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Financial Ratio Analysis

What are some of the setbacks when considering the use of financial ratios?

Ratios based on historic cost accounts do not give a truly vivid picture of the
trends in the industry; this is because of the effects of inflation, the time value of
money, and the different accounting policies. Ratios commonly used by investors
tend to have more challenges because investment means looking into the future
and the past may not always predict properly the future.

 The use of different accounting policies may not properly help align of
compare the ratios accurately
 Companies may not be of similar of same size, this is most applicable to
performance ratios
 Although companies may operate in the same industry, their target markets
may differ and therefore, segmental accounting must be taken into
consideration.

Seasonal Factors That Distort Ratio Analysis

Financial ratios are calculations developed using data from a company’s financial
statements. Managers, investors and lenders analyze financial ratios for
indications of a company’s performance and financial health. Although financial
ratios are important analytical tools, they are subject to limitations. Seasonal
factors predictable events that are common to your type of business or industry
can affect the interpretation of financial data and distort analysis of financial
ratios.

Financial ratios are named based on the type of information provided. For
instance, liquidity ratios answer questions about a company’s ability to quickly
liquidate assets to meet current liabilities. Other financial ratios are leverage,
profitability and asset management or activity. Effective analysis of these financial
ratios requires the use of reference points or benchmarks for comparison.
Understanding how seasonal factors affect the financial information can prevent
misinterpretation.

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Financial Ratio Analysis

1. Seasonal Products and Services

An off-season lull in business may distort analysis of activity or profitability ratios

for companies that sell seasonal products or services. Seasonal inventory or
revenue fluctuations that are not based on sales can artificially inflate or deflate
the value of the company’s assets. For instance, the financial statements of a
company that waits to purchase large amounts of inventory during the off-season
to benefit from lower prices might appear to show poor sales when inventory is
high or poor liquidity when inventory is intentionally low. Avoid devaluing
company assets and distorting inventory turnover rates by using an average
monthly inventory instead of beginning and ending inventories to calculate
activity or asset management ratios.

2. Weather

Predictable extreme weather or seasonal changes can distort analysis of financial

ratios, especially with comparisons of companies from different geographical
regions. A lumber company that supplies the construction industry might expect a
decrease in revenue during normal, seasonal weather conditions in one part of the
country. The financial information used to calculate ratios for a lawn care or
roofing business might reflect low revenue or increased expenses during certain
seasons of the year. Analysis of financial ratios must include consideration of
weather-related factors. Companies can address distortion of revenue and
expenses by performing historical comparisons of the same accounting period
over a period of a few years.

3. Holidays

Companies that focus on the sale of holiday items or services often have a limited
period of activity reflected in financial statements. Financial statements will not

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Financial Ratio Analysis

reflect a balance of financial activity throughout the year. The company can adopt a
fiscal year, or accounting periods that help showcase its most active periods. To
calculate financial ratios, accountants can use formulas to distribute sales,
expenses and inventory turnover rates over the fiscal year or accounting periods.
Choosing reference points that are relevant to the business type prevents
distortion when comparing companies.

What Precautions Must One Take When Using Ratio Analysis to Make
Financial Decisions?
Company financial statements are a critical component when using ratio analysis
to make business decisions. Financial statements contain a variety of fiscal data for
a company, including total revenues, financial obligations and net profits. Flawed
financial statements can lead to incorrect or flawed data when using ratio analysis.
Ensuring that all fiscal data contained on company financial statements is correct
is mandatory before proceeding with ratio analysis. Failing to do can result in a
unwise business decisions that can harm total earnings.

Inflation is the rate at which the price for goods and services increases over time.
As inflation rises, the value of money decreases because it takes more cash to buy
the same amount of product. The rate of inflation varies depending on prevailing
economic conditions. Adjusting for inflation is necessary when performing ratio
analysis because the cost of goods and services can change by the time a business
finishes compiling the necessary data. Failing to make these adjustments results in
inaccurate data from the moment the accountant finishes the company's ratio
analysis.

Creating a ratio analysis heavy with accounting terminology makes the document
difficult to understand for those who don't have accounting certifications or
degrees. Eliminating discipline-specific terminology in favor of plain language
allows a business owner to understand and interpret the data without an
accounting dictionary. Using simple language also reduces the risk of a
misinterpretation in the data resulting from a confused accounting term. This type

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Financial Ratio Analysis

of error can cost a business a lot of money depending on the type of fiscal decision
made as a result of the ratio analysis.

Illustration 1

Balance Sheet ($ in Millions)

Assets 1998 Liabilities and Owners' Equity 1998
Current Assets Current Liabilities
Cash 500 Accounts Payable 300

Accounts Receivable 700 Notes Payable 200

Inventory 800 Total Current Liabilities 500

Total Current Assets 2000 Long-Term Liabilities

Long-Term Debt 1100

Fixed Assets Total Long-Term Liabilities 1100

Property, Plant, and Equipment 1200 Owners' Equity

Less Accumulated Depreciation 600 Common Stock ($1 Par) 700

Net Fixed Assets 600 Capital Surplus 100

Retained Earnings 200

Total Owners' Equity 1000

Total Assets 2600 Total Liabilities and Owners' Equity 2600

Income Statement ($ in Millions)

1998
Sales 1400

Cost of Goods Sold 1200

Administrative Expenses 300

Depreciation 394

Earnings Before Interest and Taxes (494)

Interest Expense 210

Taxable Income (704)

Taxes (273)

Net Income (431)

Dividends 0

Addition to Retained Earnings (431)

Other Information
Number of Shares Outstanding (Millions) 700
Price per Share 11.05

 The Current Ratio is 4.

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Financial Ratio Analysis

Where:
Total Current Assets = $2000
Total Current Liabilities = $500

 The Quick Ratio is 2.4.

Where:
Total Current Assets = $2000
Inventory = $800
Total Current Liabilities = $500

 Return on Assets (ROA)

The ROA is -16.58%.

Net income

Total assets

Where:
Net Income = $-431
Total Assets = $2600

 Profit Margin

The Profit Margin is -30.79%.

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Financial Ratio Analysis

Where:
Net Income = $-431
Sales = $1400

Total Assets Turnover

The Total Assets Turnover is 0.54 times.

Sales
Total assets

Where:
Sales = $1400
Total Assets = $2600

 Earnings per Share

The Earnings per Share (EPS) is $-0.62.

Where:
Net Income = $-431
Number of Shares Outstanding = 700

 Debt Ratio

The Debt Ratio is 61.54%.

Total debt

Total assets

Where:
Total Assets = $2600
Total Owners' Equity = $1000

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Financial Ratio Analysis

Note: Total Debt is computed by subtracting Total Owners' Equity from Total Assets.

 Return on Equity (ROE) or Return on Shareholders’ Equity

The ROE is -43.1%.

Where:
Net Income = $-431
Total Owners' Equity = $1000

 Fixed Assets Turnover

The Fixed Assets Turnover is 2.33 times.

Sales
Fixed assets

Where:
Sales = $1400
Net Fixed Assets = $600

These financial ratios are very self-explanatory and easily applicable. It is important to
note that ratios may be modified to fit desired information necessary and they don’t
compulsorily come in a static manner, they are flexible and can be used in many
different ways for different interpretations and scenarios. It is also important to refer
to the units to which there ratios are deducted; percentage, days, times, etc.

References

 www.wikipedia.com
 www.zenwealth.com

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Financial Ratio Analysis

 www.123helpme.com
 www.ofs.edu.sg
 www.pitt.edu
 www.brianmass.com
 www.educationuk.org (British Council)
 www.acorn.com
 The Basics of Business Finance by John McMillan
 Financial Ratio Analysis by Pamela Peterson Drake

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