A ratio is used in financial analysis

A ratio is a yardstick used in financial analysis to evaluate a company’s financial situation and performance. It is a technique for analyzing and interpreting financial statements. Ratio analysis aids decision making by establishing a relationship between various ratios and their interpretation. Ratio analysis assists analysts in making quantitative judgments about the firm’s financial status and performance. When trends are discovered, comparative ratios are provided, and interrelated ratios are generated, the effectiveness of ratios can be improved. This paper analyses the uses of liquidity, profitability and solvency ratios and finally looks at DO &CO financial ratios based on financial statements for the year 2015 and 2016.

Uses of Ratios

Liquidity Ratios

Also referred to as working capital ratios liquidity ratios measure the ability of the company to meet its short-term maturing financial obligations as and when they fall due. Liquidity ratios are concerned with current assets and current liabilities, and they include current ratio, quick ratio, cash ratio and Networking capital ratio. The current ratio calculated as Current Assets /Current Liabilities is used by companies to determine the number of times the current liabilities can be paid from current assets before those assets are depleted.A ratio of 2.0 is most recommended, i.e., the current assets must be twice as high as current liabilities (Velez, 2012).

The quick ratio or rather acid test ratio calculated as (Current Assets-Stock)/Current liabilities is a more refined current ratio which excludes amount of stock of the firm since they are valued on a historical cost basis and may not be converted into cash very quickly. It is used to measure the ability of the firm to pay its current liabilities from the more liquid assets of the firm (Velez, 2012).

The Cash ratio calculated as (Cash in hand +short term marketable securities)/Current Liabilities is a refinement of the quick ratio showing the ability of the firm to meet its current obligations from its most liquid resources. Short-term marketable securities refer to a short-term investment of the firm which can be converted into cash within a short period, e.g., treasury bills and commercial paper. Finally the Net Working Capital Ratio calculated as (Networking Capital/Net Assets)*100 where Net Assets=Total Assets –Current Liabilities. Expressed in percentage this ratio is used to indicate the proportions of total net assets which is liquid enough to meet the current liabilities of the firm (Velez, 2012).

Solvency Ratios

Also referred to as Leverage ratios solvency ratios measure the extent to which the firm has obtained fixed charge capital to finance the acquisition of the assets and other resources of the company. The basic solvency ratios include Debt/Equity ratio and fixed charge to total capital ratio. The Debt/Equity ratio calculated as Fixed Charge Capital/Equity indicates the amount of fixed charge capital in the firms capital mix for every one euro of owner’s capital, e.g., a ratio of 0.78 means for every $1 of equity there is $0.78 fixed charge capital. The fixed charge to total capital ratio calculated as (Fixed Charge capital/Total capital employed)*100 is used to indicate the amount of fixed charge capital in capital employed by the firm. For instance, a ratio of 0.38 means that 38% of the capital employed is fixed charge capital (Velez, 2012).

Other Solvency ratios are Debt ratio and Time interest earned ratio. Debt ratio calculated as Total Debts/Total Assets is used to indicate the proportion of total assets that have been financed using long-term and current liabilities, e.g., a debt ratio of 0.45 mean 45% of total assets has been financed with debt while the remaining 55% was financed with owner’s equity/capital. Time interest earned ratio calculated as operating profit/Interest Charges indicates used to indicate the number of times interest charges can be paid from operating profit. The higher the TIER, the better the firm indicating that the firm has high operating profits or its interest charges are low. If TIER is high due to low-interest charges, this means a low level of debt capital was employed by the firm (Velez, 2012).

Profitability Ratios

Profitability ratios are used to measure the performance of the firm about its ability to derive returns or profit from investment or sale of goods. Profitability ratios are classified into two, i.e., profitability about sales and profitability in relation to investment. Profitability in relation to sales ratios is used to indicate the capability of the firm to control its cost of sales, financing and operating expenses.They include Gross Profit Margin, operating profit margin and Net profit Margin (Velez, 2012).

The Gross Profit Margin calculated as (Gross profit/Sales)*100 is used to indicate the ability of the firm to control the cost of sales expenses.For example, a gross profit margin of 50% means 50% of sales revenue was taken up by the cost of sales while 50% was the gross profit. The operating profit margin calculated as (EBIT/Sales)*100 indicates the ability of the firm to control its operating expense such as distribution cost, salaries, and wages, traveling, telephone and electricity charges, etc. For instance, a ratio of 20% means 80% of sales relate to both operating and cost of sales expenses while 20% of sales remained as operating margin profit. The Net Profit Margin calculated as (Net Profit +interest/Sales indicates the ability of the firm to control funding expenses in particular interest charges. For example, a net profit margin of 10% indicates that 90% of sales were taken up by costs of sales, operating and financing expenses while 10% remained as net profits (Velez, 2012).

Profitability ratios about investment include Return on Investment (ROI), Return on Equity (ROE) and Return on Capital Employed (ROCE).The ROI calculated as (Net Profit/Total Asset)*100% is used to indicate the return on profit from the investment of $1 in total assets, e.g., a ratio of 20% means $10 of total asset generated $2 of net profit. The return on equity calculated as (Net Profit/Equity)*100% is used to indicate the return of profitability for every one dollar of equity capital contributed by the shareholders, e.g., a ratio of 25% means one dollar of equity generates $0.25 profit attributable to ordinary shareholders. The return on capital employed calculated as (Net Profit/Net Asset)*100 is used to indicate the returns of profitability for every one dollar of capital employed in the firm (Velez, 2012).

DO & CO Financial Statements

Financial Ratios

2016

2015

Current Ratio

= Current Assets / Current Liabilities

=332.69/192.89

=1.7

=204.82/155.29

=1.3

Profit Margin

= Net Income / Net Sales

=(55.51/916.47)*100%

=6.1%

=(54.19/798.92)*100%

=6.8%

After tax ROE

=(Net Profit/Equity)*100%

=(44.69/254.37)*100%

=17.6%

=(46.33/246.74)*100%

=18.8%

Interpretation

The current ratio of DO & CO in the year 2015 was 1.3 while at 2016 was 1.7.In the year 2015 the company’s ability to meet its financial obligation when and as they fall due was low as compared to 2016 whereby the company’s current assets was almost twice the current liabilities. The Net Profit of the company reduced from 6.8 % in the year 2015 to 6.1% in the year 2016.This means 93.2% of profits were taken up by the cost of sales and other operating expenses in the year 2015 while in the year 2016, 93.9% of profits were taken up by the cost of sales and other operating expenses an indication that company’s expenses increased in the year 2016.The return on equity of the company was 18.8% in the year 2015 and 17.6% in the year 2016.This means that one euro of equity generated $0.188 profit attributable to ordinary shareholders in the year 2015 while in the year 2016 one Euro of equity generated $0.176 profit attributable to ordinary shareholders an indication of decline in profits attributable to shareholders in the year 2016 (DO &CO, 2016).

Conclusion

Ratio analysis is a vital tool in business not only to financial analysts but also to investors and managers. Ratios are useful in evaluating the efficiency of asset utilization in generating revenue. Also, ratios are useful in evaluating the ability of the firm to meet its short-term financial obligation as and when they fall due. Additionally, ratios are used to carry out industrial analysis as well as cross-sectional analysis, i.e., comparing the performance of the firm with that of individual competitors in the same industry. Finally, ratios can be used to predict the bankruptcy of the firm.

Reference

DO & CO. (2016, May 31). Reports Business Year and Quarters. Retrieved from http://www.doco.com/en/ir/reports/reports-business-year-and-quarters

Velez-Pareja, I. (2012). Financial Analysis and Control - Financial Ratio Analysis (Slides). SSRN Electronic Journal. doi:10.2139/ssrn.1638279