Analyzing Financial Data with Ratios in Accounting
Big Picture Questions
When an accountant conducts a financial analysis of a firm, he or she tends to first look at the big picture pertaining to a company, and in doing so, asks the following questions:
- What assets does the company already have in place? What is their value?
- What are the company's growth assets? What is their value?
- What does the firm earn for the assets it currently has in place? What does it expect to earn for these same assets, in addition to its growth assets?
- What specific mix of debt and equity is the company using to finance its assets?
- What amount of risk is associated with making an investment in the company?
- What is the cost of its debt and equity financing?
Range of Ratios
In attempting to evaluate the numerical data contained within a company's financial statements, accountants employ a spectrum of ratios. Using accounting ratios to assess business performance is a helpful tool in terms of being able to evaluate the financial results of a business from a performance standpoint.
Furthermore, ratios provide accountants and business owners with the means to compare a company against sets of several different standards using figures obtained from the balance sheet.
While accounting ratios have the potential to offer invaluable insight into a business's performance, it is highly critical that the data used for comparison purposes is accurate and current; otherwise, results will prove to be irrelevant.
Four of the most common areas to which accountants apply ratios are liquidity, efficiency, solvency, and profitability.
Liquidity: These ratios indicate the availability of cash and the company's ability to pay liabilities.
The following formulas for ratios are used to assess a company's liquidity:
Current ratio: Current assets divided by current liabilities.
Acid test (liquidity ratio): Cash, cash equivalents, and receivables divided by current liabilities.
Day's sales in receivables: Accounts receivable divided by credit sales divided by number of days.
Inventory turnover: sales divided by inventory. A low turnover could translate to poor sales (too much inventory). A high ratio could mean robust sales.
Capital and long-term solvency: The term "gearing" is used to indicate solvency and is determined by comparing owners' equity (capital) with borrowed funds (long-term loans, bank overdrafts, etc.).
The higher the gearing, the more vulnerable the company is to continually increasing interest rates. Past 50 percent, the majority of lenders will refuse to offer further financing.
The following solvency ratios indicate the firm's ability to meet debts as they come due:
- Debt/equity ratio: total liabilities divided by owners' equity.
- Total equity to net fixed assets: total equity divided by fixed assets.
Efficiency ratios: average amount of time required by a company to both collect and make payments.
Here are the four types of efficiency ratios:
- Debtors' turnover: Representative of the length of time a company needs to collect payments, it is found by taking the Net Credit Sales and dividing it by the Average Trade Debtors. Low ratios usually are "wake-up calls" that tighter controls need to be placed on payment terms.
- Creditors' turnover: Defined as the Credit Purchase divided by the Average Trade Creditors, this ratio identifies the length of time a company requires to pay suppliers. This is an important ratio for a company to look at because suppliers may eventually decide to withdraw credit if the company is repeatedly late with remuneration.
- Inventory turnover: Sales divided by inventory. A low turnover could translate to poor sales (too much inventory). A high ratio could mean robust sales.
- Total asset turnover: Shows how effective the company is at using both short-term and long-term assets by taking the revenue and dividing the average of the total assets.
Profitability: This is the amount by which a company covers its costs, pays back loans due, and puts aside money for working capital.
The following ratios are used to indicate a company's performance, or profitability:
Gross profit margin: gross profit divided by sales.
Net income to sales: net income divided by sales.
Operating income to sales: income before income taxes divided by total assets.
Return on total assets: net income and interest expenses divided by total assets.
Return on equity: net income divided by total equity.
Originating from the root word "profit," which in Latin means "to make progress," profitability can be defined in two ways:
- Pure economic profit: This term refers to increase in wealth, such as the profit an investor gets by making an investment. Within this realm, one needs to consider all associated costs with the investment, including the opportunity cost of the capital and rate of interest.
- Accounting profit: This is the difference between the retail sales price of an item and the cost to manufacture it.
When attempting to figure out which definition of profit to use, part of the difficulty is a result of having to define costs. For instance, even at a state of complete equilibrium, the accounting profit may be positive while the pure economic profits remain at zero.
For this reason, when calculating accounting profits, economic profits (EPs, also known as economic rents) should be added into the equation.
There are several types of profit in the world of accounting:
Economic profit (EP): Measurement of a single period used to determine the worth of a company within that isolated time frame, which typically is a year. The formula for calculating the economic profit is the net profit after tax less the equity charge.
Gross profit: Profit amount before selling and "general and administrative costs" (SG&A) such as depreciation and interest are calculated into the mix. The formula is sales less direct cost of goods or services sold (COGS).
Net profit, pre-tax: This is a company's pre-tax sales figures minus costs such as wages, rent, fuel, raw materials, interest on loans and depreciation.
Net profit, after tax: This figure will include deduction of either corporate tax in the case of a company or income tax in the case of an individual.
Operating profit: This refers to the measure of a company's earning power as determined by analyzing figures from previous operations. This amount should equal that of earnings before the deduction of interest payments and income taxes.
Accountants Estimating Profitability
Based upon an income statement, accountants can estimate the profitability of a company in absolute terms. Yet accountants also need to be able to detect the profitability of a company in terms of percentage returns.
To measure profitability, the two basic methods employed by accountants are:
- Rate on investment (ROI): This method will help determine the company's profitability as it relates to the capital. This can be done either from the perspective of the equity investors or by viewing the company as a whole.
- Profit margin: This method will help determine the company's profitability as it relates to sales.
In this article, we will begin to discuss both asset management and asset valuation.
Often used to refer to the practice of managing a client's collective investment holdings, or portfolio, asset management is an accounting process in which the activities of fixed assets are monitored from such vantage points as financial accounting, preventive maintenance, and theft deterrence.
In layman's terms, asset management is the process of monitoring fixed assets to verify their value, ensure their protection, and support their growth potential.
Because the overall goal of managing either an individual's or a company's financial assets is to maximize returns, it is important to ensure that the quality and condition of assets remain in pristine condition.
However, because of external forces such as environmental conditions, maintenance, market trends, etc., it is often incredibly difficult to a) keep a handle on the status of all respective assets and b) guarantee the asset will yield a consistent value.
Because of the level of difficulty that is involved in monitoring large-scale asset holdings, many companies have turned to software tracking systems and imbedded chip codes. These devices help to streamline the entity's efforts to maintain tabs on assets and, whenever possible, ascertain their condition.
Going well beyond the traditional management practice of examining singular systems, asset management proves to be a comprehensive and structured approach to the long-term management of assets as tools for the efficient and effective allocation of resources.
Asset Management: Strategy for Improvement
In addition to ensuring maximum returns, asset management also helps business owners ascertain the best use of resources. For instance, computer hardware is viewed to be an asset. The quantity of computers allocated among various departments and the proficiency of these machines proves to be a major contributor to productivity levels.
The guiding principles of asset management should be:
- System-oriented (as opposed to single-focused);
- long-term in outlook;
- accessible and user-friendly;
Along these same lines, an asset management system should include such elements as:
- strategic goals;
- inventory of assets (tangible, intangible, and human resources);
- valuation of assets (see section that follows);
- quantitative condition and performance measures;
- metrics identifying degree to which strategic goals are being met;
- usage data;
- performance-prediction abilities;
- consideration of qualitative issues;
- engineering and economic analysis tools;
- forums for continuous feedback and monitoring.
In line with the concept of asset management, asset valuation is the process of determining the current worth or market value of either one item, such as an asset or a liability, or all holdings within the company's portfolio or on its balance sheet.
The purpose of conducting a valuation of a business's assets, liabilities (fractional interests), or overall holdings is to present an accurate picture of its financial status. As such, valuations tend to occur in tandem with possible mergers or acquisitions, sales of business subdivisions, sales of securities, initial public offerings, and/or tax-related activities.
In terms of personal situations, valuations tend to be conducted as preparation for divorce settlements, basic bookkeeping/accounting, and the creation of wills and estates.
The usefulness of a valuation, however, depends heavily upon the reliability of the company's financial data.
Models used to conduct valuations of companies' financial assets include:
- Relative value: Values are determined based upon the market prices of similar types of assets.
- Absolute value models: Values are determined based upon estimates of expected future earnings whereby the asset was owned but discounted to its present value.
- Optional pricing models: These are used specifically with more complex types of financial assets, such as call options, employee stock options, and investments with embedded options. The most common are the Black-Scholes-Merton models, used to estimate the value of employee stock options using a closed-form equation and lattice models.
With respect to assigning values to assets, several terms tend to be frequently used: fair market value, fair value, and intrinsic value.
Fair market value: The most common of the three associated terms, this refers to the cash selling price between a willing buyer and willing seller, so long as they both are knowledgeable of the related facts and have no compulsion to buy or sell.
Fair value: This term actually has several different meanings, although many use it interchangeably with fair market value. Reflective of current changes within the market, the fair value of an asset is the amount at which that asset may be bought or sold during a transaction, outside of liquidation, between willing parties. It is used in generally accepted accounting principles (GAAP) for financial reporting.
Within an active market, quoted market prices are the best evidence of fair value. As such, they are used as the basis for measurement. Because quoted market prices for an asset are often unavailable, estimates of fair value can be used. However, as a result, problems frequently arise when attempting to make estimates of fair value.
As finance expert Tony Sondhi, Ph.D., of A. C. Sondhi & Associates in Maplewood, N.J., relayed in a recent online interview, "All nonmarket-based fair values are subjective because they are both based on and sensitive to the estimates, assumptions, and measurement methods management uses to determine fair value. ... However, subjectivity need not be a deterrent to using fair value accounting. Whether we like to admit it or not, estimated fair values are the basis of our economic decisions."
Intrinsic value: As the name implies, this is the asset's true value, regardless of the market price's reflection.
Should an analyst determine a stock's intrinsic value to be greater than its market price, then he or she issues what is known on the "trading floor" as a "buy" recommendation. However, should the analyst find a stock's intrinsic value to be less than its market price, he or she is likely to issue a "sell" recommendation.
As you can probably guess, ascertaining an asset's intrinsic value may not be easy. This is because intrinsic values do not have a concrete basis upon which assets may be judged. Therefore, such conclusions tend to heavily rely upon a wealth of differing opinions.
Because the estimated worth of material goods, in addition to many intangible items, tends to regularly fluctuate over time, many opt to conduct valuations at regular intervals throughout the year, as opposed to only on an annual basis. Some may even use valuations on a spot-check inventory purpose by which they are able to make decisions regarding their portfolios and associated risks related to select key investments.
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