Module 4. Financial statement analysis

Lesson 19

19.1 Introduction

Careful financial statement analysis usually means the extraction of meaningful ratios from the statements. These ratios have been classified as measuring (1) Liquidity (current ratio, acid-test ratio, etc.) (2) Activity (receivables turnover, inventory turnover, etc.) (3) Profitability (profit margin on sales, rate of return on assets, earnings per share, etc.) and (4) Leverage (debt to total assets, times interest earned, etc.). Ratios are often used to assess performance or as diagnostic tools to point up potential problem areas. Given the extremely varied entities for which financial statements are made -- and even the extreme variation between industries of an entity type -- the most productive use of these ratios is probably made either against industry standards or against ratios for previous years of the entity in question

19.2 Ratio Analysis

Ratios are useful to indicate various symptoms. Usually those symptoms require more detailed analysis. For example, ratio analysis may reveal an increase in sales volume relative to inventory and receivables. But inventories could have increased less rapidly than sales due to reduced cost of goods, inability to replace inventory items, change in inventory policy or a change in inventory valuation. Receivables could have increased less rapidly than sales because of a more efficient collection policy, a larger proportion of cash sales or a change in policy with regard to the extension of credit. Sales volume could have increased due to plant expansion, an aggressive sales campaign, price increase, price decrease or extension of sales territories. Ratio changes lead managers to ask pointed questions.

19.3 Role of Ratio Analysis in Financial Management

The financial statements provide a summarized view of operations of a firm. Various tools are employed in analyzing the financial information. Ratio analysis is one of the tools used.

(1) Ratio analysis simplifies the comprehension of financial statements. Ratio tells the whole story of changes in the financial condition of the business.

(2) Ratio analysis provides data for inter-firm comparison. If highlight the factors associated with successful and unsuccessful firms.

(3) It also makes possible comparison of the performance of the different divisions of the firm.

(4) It helps in planning and forecasting. The purpose of financial mgt to convey an understanding of some financial activities of a business firm.

19.4 Liquidity Ratios

A class of financial metrics that is used to determine a company's ability to pay off its short-terms debts obligations. Generally, the higher the value of the ratio, the larger the margin of safety that the company possesses to cover short-term debts.

Common liquidity ratios include the current ratio, the quick ratio and the operating cash flow ratio. Different analysts consider different assets to be relevant in calculating liquidity. Some analysts will calculate only the sum of cash and equivalents divided by current liabilities because they feel that they are the most liquid assets, and would be the most likely to be used to cover short-term debts in an emergency.

A company's ability to turn short-term assets into cash to cover debts is of the utmost importance when creditors are seeking payment. Bankruptcy analysts and mortgage originators frequently use the liquidity ratios to determine whether a company will be able to continue as a going concern

Investor look at liquidity ratios to determine the ability of a business to pay off its short term obligations from cash or near cash assets to evaluate the risk associated if were to invest in this company. Failure to pay off short term obligation may resulted in financial difficulty or bankruptcy in near future.

Liquidity ratios help investors to minimize the risk in stock market investment to screen out financial sound companies on stock pick to build up their "buy and hold" portfolio.

Table 19.1 Characterization of cash ratio

Cash Ratio

<= 1

Dangerous Zone. Very low liquidity.

1 <

Cash Ratio

Short term debt can be paid in full with cash and

near cash items.

2 <

Cash Ratio

Bad management of short term liquidity. Cash

could be invested in longer term assets earning a

higher return.

Cash Ratio: Cash ratio measure the ability of a business to meet short term obligations. It measures to the extent which current obligations can be paid from cash or near cash assets.

Cash ratio = (Cash and Cash equivalents) / Current Liabilities

A liquidity ratio measures a company's ability to pay its bills. The denominator of a liquidity ratio is the company's current liabilities, i.e., obligations that the company must meet soon, usually within one year. The numerator of a liquidity ratio is part or all of current assets. Perhaps the most common liquidity ratio is the current ratio, or current assets/current liabilities. Because current assets are expected to be converted to cash within one year, this liquidity ratio includes assets and liabilities of equal longevity. The problem with the current ratio as a liquidity ratio is that inventories, a current asset, may not be converted to cash for several months, while many current liabilities must be paid within 90 days. Thus a more conservative liquidity ratio is the acid test ratio -- (current assets - inventory)/current liabilities -- which excludes relatively illiquid inventories. The most conservative liquidity ratio is the cash asset ratio or the cash ratio, which includes only cash and cash equivalents (usually marketable securities) in the numerator. Finally, note that the liquidity ratio sometimes means the cash ratio.

Liquidity means ability to clear the current liabilities. The arithmetical expression between the current liabilities and current assets is called liquidity ratio. The ideal ration is 2:1

Formula for Liquidity Ratios:


Net Working Capital = Current Assets - Current Liabilities

Last modified: Saturday, 6 October 2012, 9:22 AM