Understanding financial performance using the technique of ratio analysis of listed companies
Companies are said to be listed (quoted) when their shares are publicly traded on a stock exchange. A systematic use of ratios is widely used by managers, creditors, regulators and investors to analyze the financial performance of listed and unlisted companies. The listed companies have an extra ratio analysis (investor ratios) which cannot be used in the unlisted companies simply because their shares are not listed on the stock market.
A ratio is a relationship between two numbers. The objective in using a ratio when analyzing financial a company’s performance is to standardize analyzed information so that ratios of different or same firms can be compared. Financial ratios provide the basis for answering some very important questions concerning the performance of a firm financially and its overall well being. (Petty et al., 2000). A brief summary of the main financial ratios and how they are used is given below:
1Profitability ratios: Gross profit, Net profit, Return on Capital Employed-Is the business able to control its production or overhead costs? 2Efficiency ratios-How efficiently is the business employing resources invested in fixed assets and working capital? 3Liquidity ratios: Current, quick ratio-How capable is the business in meeting its short-term obligations as they fall due? 4Stability ratios: eg. Gearing-How healthy is the business in the long-term financially? 5Investor ratios: EPS, Price earning ratio, Dividend yield-Are the investors receiving sufficient return on their investment?
Critical evaluation of the financial ratios
Ratio analysis used with care, can reveal much about a company and its overall operations and image to stakeholders but there are things to bear in mind: -A ratio has no single correct value. The observation of a too high or too low ratio depends on the perspective of the analyst and the competitive strategy of the company. For example, from the short-term creditor point of view, a high current ratio suggests a high likelihood of repayment because of the ample liquidity. Yet to the company owner the same ratio suggests that company’s assets are being used too conservatively. On the other hand, from an operating point of view, a high current ratio could indicate conservative management. Therefore in any case, the main point is not whether the ratio is too high or low but whether the strategy chosen is best for the company. (Higgins 2000)
A ratio is simply tells the relationship between two numbers, it is unreasonable to use the calculation of one or several ratios to automatically give insights to the modern corporations that operate in an ever changing environment. In general the real values derived from financial ratios analysis is that they tell us what questions to ask. Some ratios might be misleading but when combined with other knowledge of a company’s circumstances, financial ratios are useful in assessing a firm’s financial condition. Analysts should be aware of potential weaknesses when performing a ratio analysis.
Pyramid of Ratios
(Lucey, 2003) states that ratio analysis as a practical means of monitoring and improving performance is greatly enhanced when ratios are prepared regularly and on a consistent basis so that trends can be highlighted and changes investigated. Ratios are prepared showing the inter-locking and inter-dependent nature of the factors which contribute to financial success and this is done using the pyramid of ratios.
Extracted from Biz/ed(www.bized.co.uk) free online service for students, teachers and lecturers of business, economics, accounting, leisure and recreation and travel and tourism The pyramid of ratios consists of the various ratios which are thought of contributing to the analysis of management performance....