Question

Describe how ratio analysis can be used to improve operations and reduce debt ?

Describe how identifying trends and patterns in financial statements over reporting periods can yield insights into the client’s business ?

Answer 1

1) Ratio analysis can be used to measure the efficiency in operations of a business. These ratios can be classified as:

Profitability ratios, asset turnover ratios and liquidity and solvency ratios.

Each of these classes of ratios help analyze different aspects of the operations of a business.

Profitability ratios:

The profitability ratios help in assessing the profitability of the operations of the firm at various stages and from various angles. These ratios may be based on sales or on investment.

The profitability ratios used are:

Gross profit ratio (Gross profit/Net sales):

The ratio gives the gross margin on sales and is expressed as a percentage. It indicates the profitability achieved before considering operating expenses.

Net profit ratio (Net profit/Net sales):

The ratio gives the % of net profit on sales. As net profit is after all expenses, the ratio shows the efficiency of total business activity.

The net profit ratio can be studied in relation to the gross profit ratio to judge the impact of operating expense on the profitabiliety of the firm.

Return on Total Assets (Net income/Total assets):

The ratio shows how efficienty the assets are used to generate income. The ratio can be compared with industry norms to judge the comparative efficiency of the firm.

Asset turnover ratios:

Fixed asset turnover ratio (Net Sales/Fixed assets):

Gives the number of times the value of fixed assets is turnover over by sales and it shows the efficiency of the overall operations.

Receivables turnover ratio (Net sales/Average receivables):

Indicates how many times the receivables are turned over. The more the ratio the higher the efficiency. 365 days/divided by this ratio gives the 'average collection period' in days which in turn measures the efficiency of the credit and collection operations of the firm. It tells whether the actual collection of receivables is in consonance with the credit and collection policieis of the firm.

Inventory turnover ratio and days sales in inventory:

The inventory turnover ratio given by Net sales/average inventory, tells how many times the inventory is turnover and can be compared with industry standards to judge the relative efficiency.

365 days divided by the inventory turnover ratio, will give the number of days sales that is blocked in inventory. The ratio can be compared with industry standards to judge the relative efficiency.

The debt position can be studied using the liquidity and solvency ratios:

Liquidity ratios:

Liquidity ratios comprise Current ratio, acid test ratio and operating cash flow to current liabilities ratio.

The current ratio, which is given by the formula Current assets/Current liabilities, measures the ability of a firm to pay off its current liabilities. The generally accepted standard for this ratio is 2, which means the current assets are twice the current liabilities and indicates a safe liquidity position. However, the norm varies from industry to industry.

But, the current ratio considers inventory and prepaid expenses as easily realizable as the other current assets like cash, marketable securities and receivables, which is not real. Hence, the more stringent acid test ratio which is got by dividing the total of cash+marketable securities+receivables by current liabilities is used. The norm for this ratio is 1 and varies with different industries.

The operating cash flow to current liabilities is still further stringent and is obtained by dividing the 'net cash from operating activities by the current liabilities.

The above ratios highlight how safe the firm's financial position is from a short term point of view. If the position is not safe, steps should be taken to improve the ratios.

Solvency ratios:

Debt to Total assets (Total debt/Total assets) measures the extent of debt that has gone to finance the total assets and indicates the riskiness of the financing. Again industry average is to be used for judging the ratio.

Detb/Equity (Total debt/Total stockholders' funds):

The ratio tells the relative funds supplied by the creditors and stockholders.

The above two ratios should be compared with industry averages and steps should be taken to reduce the debt content if it is high.

2) Trends and patterns in financial statements:

The figures in the balance sheet and profit and loss account for a period of years can be compared in a relative way by expressing the line items in those statements from the second year as percentages of the first year figures. This means that the first years' figures are to be taken as 100% and the subsequent years' figures are to be expressed as percentages of the first years' figures.

This would enable to study the trend in certain aspects of the business. For instance the trend in gross profit can be compared with the trend in net profit, to judge the change in efficiency in operations at different levels. An increase GP percentages with a corresponding decrease in net profit figures would indicate decreasing efficiency in the selling and administrative operations.

Similarly trends in current assets and current liabilities along with trend in sales figures can indicate how the working capital position has moved in relation to the sales.