2 4 Types of analysis using accounting ratios in decisions
making
2 4 1 Analyzing Liquidity
Liquid assets are those assets that can be converted into cash
quickly. The short-term liquidity ratios show the firm's ability to meet
short-term obligations. Thus a higher ratio (#1 and #2) would indicate a
greater liquidity and lower risk for short-term lenders. The Rule of Thumb (for
acceptable values): Current Ratio (2:1), Quick Ratio (1:1) While high liquidity
means that the company will not default on its short-term obligations, note
that by retaining assets as cash, valuable investment opportunities might be
lost. Obviously, Cash by itself does not generate any return only if it is
invested will we get future return. In quick ratio, we subtract the inventories
from total current assets since they are the least liquid (among the current
assets. (Prof. Phill Russeil, 2003)
Since the cash is the most liquid asset, a financial analyst
may examine the ratio of cash and its equivalent to current liabilities. Trade
investment and marketable securities are equivalent of cash therefore they may
be included in the computation of current ratio. (I.M Pandey, 1995: 112).
1. Current Ratio = Total Current Assets/Total Current
Liabilities
2. Quick or Acid-test Ratio = Total Current Assets - Inventories
/Total Current Liabilities
3. Cash ratio = Cash + Marketable securities/Current
liabilities.
These ratios show the extent to which a firm is relying on
debt to finance its investments/operations and how well it can manage the debt
obligation. Obviously, if the company is unable to repay its debt or make
timely payments of interest, it will be forced into bankruptcy. On the positive
side, use of debt is beneficial as it provides valuable tax benefits to the
firm. Note total debt should include both short-term debt (bank advances +
current portion of long-term debt) and long-term debt (such as bonds, leases,
and notes payable). (Prof. Phill Russeil, 2003).
Asset-Equity Ratio or Leverage Ratio= Assets/Shareholder's
Equity
This shows firm's reliance on external debt for financing (or
the degree of leverage). Any number above 100% shows that the company relies on
external debt for financing some of its assets. If the number equals 100%, it
implies that the assets are fully financed by the shareholders.
Some analysts tend to use the Debt ratio (given by total
Debt/total assets) or Debt/Equity ratio given by total long-term debt/equity).
These ratios also show company's reliance on external sources for financing its
assets. (Prof. Phill Russeil, 2003)
1. Total Debt ratio = Total Debt/Total assets
2. Debt-Equity Ratio = Total Debt/Equity
3. Long-term Debt to capital = Debt/Debt + Equity
For a lender, more important than the degree of leverage is the
firm's ability to service the debt and this is captured in the following
ratio.
2 4 3 Analyzing Sales and Profitability
Profitability is a relative term. It is hard to say «what
percentage of profits» represents a profitable firm as the profits will
depend on the product life cycle, competitive conditions in the market,
borrowing costs, expense management. Analysts will be interested in the
(historical and forecasted), the set of ratios here include some of the
traditional earnings based performance
measures such as ROS, ROA, ROI, and ROE. For a better
understanding of growth rates, it will be useful to know the «real growth
rate» as opposed to «nominal growth rate». For example, it is
quite possible that the sales growth rate figures are impressive due to
inflation (rather than an increase in the number of items sold). (Prof. Phill
Russeil, 2003).
The following are ratios selected to analyse profitability and
sales ;
1. Sales Growth Rate = {(Current year sales - last year
sales)/last year sales} * 100
2. Expense analysis = various expenses /Sales
3. Gross Margin/Sales = Gross Profit/Total Sales
4. Operating Profit/Sales = Operating Profit/Net Sales
5. EBIT to Sales = EBIT/Net Sales
6. Return on Sales (ROS) or net profit ratio = Net Income/Net
Sales
7. Return on Investment (ROI) = Net Income/Total Assets
8. Return on Assets (ROA) = Net Income/Total Assets
9. Return on Equity (ROE) = EAT/Shareholders' Equity
10. Payout ratio = Cash Dividends/ Net Income
11. Retention ratio = Retained Earnings/Net Income
12. Sustainable growth rate (SGR)= ROE * Retention Ratio
It is useful to disaggregate the ROE figure into three
elements as follows to get a better insight 13 ROE = {Net Income/Sales} *
{Sales/Assets} * (Assets/Equity)
The above formulation clearly shows that if management wishes
to improve their ROE, they need to improve profitability, efficiently use the
assets, and optimize the use of debt in their capital structure.
SGR shows how much the company will grow in the future if some
of the key ratios remain the same as in previous years. It is useful to
disaggregate the sustainable growth rate (SGR) as follows.
? SGR = f (Profitability, Asset Efficiency, Leverage, Dividend
policy)
· SGR = Return on Sales * Asset turnover ratio * Leverage *
Retention ratio
· SGR= (Net income/sales) * (sales/assets) *
(assets/equity) * (RE/net income)
2 4 4 Analyzing Efficiency
These ratios reflect how well the firm's assets are being
managed. The inventory ratios show how fast the inventory is being produced and
sold. Ratio #1 shows how quickly the inventory is being turned over (or sold)
to generate sales higher ratio implies the firm is more efficient in managing
inventories by minimizing the investment in inventories. Thus a ratio of 12
would mean that the inventory turns over 12 times or the average inventory is
sold in a month. Some High ratio by itself does not mean high level of
efficiency as high ratio could also mean shortage. Ratio #2 is referred to as
the «shelf-life» i.e. how many days the inventory was held in the
shelf. Ratio #3 shows how much sales the firm is generating for every currency
unit of investment in assets, naturally, higher the better. However, note that
this ratio is biased (as assets are listed at historical costs while sales are
based on current prices). Ratios #4 and #5 show the firm's efficiency in
collecting from credit sales. While a low ratio is good it could also mean that
the firm is being very strict in its credit policy, which may drive away some
customers. Ratios #6 and 7 focus on efficiency in making payments. (Prof. Phill
Russeil, 2003)
1. Inventory Turnover = Cost of Goods Sold/Average Inventory
2. Days in Inventory = (Average Inventory/Cost of Sales)*365
3. As sets turnover = Net Sales/Total As sets
4. Receivables Turnover = Credit Sales/Accounts Receivables
5. Average Collection period = (Accounts Receivable/Net Sales)*3
65
6. Accounts Payable turnover = Purchases/Accounts Payable
7. Days AP outstanding = (Accounts Payable/Cost of Sales)*3
65
2.4.5 Multiple Discriminant Analysis
The use of MDA helps to consolidate the effect of a set of
ratios by looking at a number of separate clues (ratios to sickness or
failure).It would be more useful to combine the difference ratios into a single
measure of the probability of sickness or failure (bankruptcy).
According to (Altman E., 1968: 589-609), as the first man to
apply discriminant analysis in finance for studying bankruptcy, his study
helped in identifying five ratios that were efficient in predicting
bankruptcy.
The model was developed from a sample of 66 firms half of which
went bankrupt. He derived the following discriminant function:
Z = 0.01 2X1+0.0 1 4X2+0.03 3X3+0,006X4+0.999X5 Z= discriminant
function score of a firm;
1. X1= net working capital/total assets (%);
2. X2= retained earning/total assets (%);
3. X3= EBIT/total assets (%);
4. X4=market value of total equity/book value of debt (%);
5. X5= sales/total assets (times)
Alman, established a guideline Z score which can be used to
classify firms as either financially sound a score above 2.675 or a headed
towards bankruptcy a score below 2.675. The lower the score, the greater the
like hood of bankruptcy and vice versa.
2.4.6 Trend Analysis
Using the past history of a firm for comparison is called
trend analysis. By looking at the trend in a particular ratio, one sees whether
that ratio is failing, rising, or remaining relatively constant. From this, a
problem is detected or good management is observed. (Charles H.GIB SON, 1989:
123).
2.5 The Components of Decision Making 2.5.1
Decision environment
decision environment would include all possible information, all
of it accurate, and every possible alternative.
However, both information and alternatives are constrained
because the time and effort to gain information or identify alternatives are
limited (Robert Version, 1998).
2.5.2 Decision Model
Decision model can be used to represent a productive system in
mathematical terms. A decision model is expressed in terms of performance
measures, constraints, and decision variables. The purpose of such a model is
to find optimal or satisfactory values of decision variables which improve
systems performance within the applicable constraints. These models can then
help guide management decision making. (ROGER G. SCHROEDER, 1985: 7).
2.5.2.1. The effects of using a decision model
A decision model has great impact on the profits of the
company. It forces the management to rationalize the depreciation, inventory
and inflation policies. It warns the management against impending crises and
problems in the company. It specially helps in following areas:
- The management knows exactly how much credit it could take,
for how long (for which maturities) and in which interest rate. It has been
proved that without proper feedback, managers tend to take too much credit and
burden the cash flow of their companies.
- A decision model allows for careful financial planning and
tax planning. Profits go up, non cash outlays are controlled, tax liabilities
are minimized and cash flows are maintained positive throughout.
- As a result of all the above effects the value of the company
grows and its shares appreciate.
The decision model is an integral part of financial
management. It is completely compatible with financial ratios analysis and
derives all the data that it needs from information extant in the financial
statements of the company.
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