Question

Because of the diversity of users, their different levels of knowledge, the varying information needs for particular decisions, and the general nature of financial statements, a variety of analysis techniques have been developed.

 Explain the ratio method of analysis and how this technique appears to provide the most relevant information in a given situation.

 Discuss 4 ratios of your choice in terms of the users, objectives, decisions and outcomes of the selected ratios.

 Select a company of your choice and calculate 4 ratios based on data extracted from the financial statements. Briefly explain the interpretation of the result.

Note: Objectives of Ratio Analysis as suggested earlier; various users approach financial statement analysis with many different objectives.

Answer 1

Ans.1. Ratio analysis is a method of analysis of financial statements of a business wherein different line items in financial statements are stated in comparison to each other. For example, net profit margin ratio shows how much is net income earned during a period relative to net sales during that period. Similarly, current ratio tells us the amount of current assets relative to the current liabilities.

Such information is of great importance to users of financial statements in their decision-making as it provides a bird’s eye view at the financials, the growth trajectory over the years, performance vis-à-vis competitors and so on.

Ratio analysis method is considered superior to many other methods, particularly because of following reasons:

1. Indication of financial position at a given point of time from various perspectives: Ratios are divided into broad categories like liquidity ratios, efficiency ratios, profitability ratios, solvency ratios, all of which provide an insight into different aspects of the business such as the liquidity position, the profitability, etc.

2. Trend analysis over the years: Ratio analysis aids in analysis of trend of financial performance of a business over the years – whether the ratios are improving year-on-year or worsening or stable.

3. Inter-company comparisons – Ratios can be used to compare performance of different companies of different sizes in the same industry. For example, in the FMCG space, one company may be a $100,000 mn turnover company and other may be a $100 mn turnover Company but the profitability of second Company may be higher. This information is brought forward only by ratios, which also enable inter-Company comparisons.

Ans.2. Four ratios and their usage is discussed as under:

1. Current ratio: This is one of the liquidity ratios. It is the ratio of current assets to current liabilities. Also, known as working capital ratio, it is majorly used by management in managing the working capital better. A current ratio of 2:1 is considered ideal ,i.e., current assets should be twice the current liabilities. This ensures current liabilities have sufficient cushion in the form of current assets. A lower ratio may indicate liquidity crunch and a higher than that ratio may indicate unutilized resources lying idle in the form of current assets. Other user of current ratio may be the creditors as they are eager to ensure that their short-term loans are secured by enough current assets.

2. Return on assets (ROA) : This is one of the profitability ratios. It is the ratio of net income to total assets employed in a business during a given period of time. It shows how effectively the Company has employed its assets to generate income for the business. Investors are primarily keen on this ratio as they would like to invest their money in Companies with higher ROA to earn higher returns.

3. Debt-Equity ratio : This is a leverage ratio which compares total debt (borrowed funds) of a business to total shareholder’s equity (owned funds). It shows how much of the total assets is currently financed by borrowed funds. This ratio is of importance to lenders/bankers who provide long-term debt to business because they would not like to lend to a business which is already highly debt-laden.

4. Inventory turnover ratio: This is one of the efficiency ratios which tells how quickly inventory is sold and converted to cash. It tells how many times inventory is converted to cash during a given period of time. Higher the ratio, the better it is. This ratio is used by management in decision-making regarding improving inventory management.

Ans.C. Please provide Company financial statements for ratio analysis.