University Financial Ratio Assignment: Analysis and Evaluation

This report provides a comprehensive overview of financial ratios, essential tools for analyzing financial statements. It begins with a background on financial ratios, explaining their relevance and purpose in evaluating a company's performance. The report delves into various financial ratios, including profitability, liquidity, and debt ratios, providing formulas and examples. It explores the uses of financial ratios by managers, investors, and auditors, along with their limitations. Key ratios such as gross profit ratio, net profit ratio, current ratio, liquid ratio, and return on investment are discussed in detail, highlighting their significance in financial analysis and decision-making. The report concludes by emphasizing the pivotal role of financial ratios in financial analysis and their importance in investment decisions.

FINANCIAL RATIO
ASSIGNMENT

1
By student name
Professor
University
Date: 25 April 2018.
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Contents
Background and Abstract............................................................................................................................3
Introduction.................................................................................................................................................3
Discussion and Analysis...............................................................................................................................3
Purpose of the financial ratios.................................................................................................................3
Commonly Used Ratios............................................................................................................................4
Different Financial Ratio..........................................................................................................................4
Conclusion...................................................................................................................................................5
References...................................................................................................................................................6
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Background and Abstract
A report has been prepared on the financial ratios which is primarily being used for analysing the
financial reports and the annual reports of the companies. The report highlights what exactly is meant
by the financial ratios, what is its relevance and purpose. There are 5 financial ratios which have also
been explained in detail along with the formula and the examples.
Introduction
The financial ratio is also called the accounting ratio and is the relative magnitude of the two numerical
values which are being taken from the financial statements. There are different types of financial
statements like that of profit and loss account, the balance sheet, the cash flow statement and the
statement of the changes in equity (Choy, 2018). Financial ratio establishes the relationship between the
two given variables and helps us to know whether the company is improving or deteriorating in terms of
the performance. This also forms the part of the financial review or analysis as well as the part of
analytical audit procedures.
Discussion and Analysis
Purpose of the financial ratios
The financial ratios is being used for a variety of reasons which has been stated below:
1. It is used by managers and management within the company or the organization to take
different types of business decisions (Alexander, 2016).
2. It is used by different types of stakeholder like that or current and potential investors to know
the performance and status of the company and to decide whether to invest in the company or
not.
3. Banks and financial institutions use it to determine whether or not to offer the credit facilities to
the company.
4. It is also being used by the auditors to compare the company with other companies, the industry
benchmarks and the ratios of the last year to check and know where the variance is and how the
same needs to be interpreted (Goldmann, 2016).
5. Ratios are useful only when the same is being benchmarked against some ratio from the past or
from the industry.
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6. There may be different types of ratio analysis like that of liquidity, solvency, performance,
activity, valuation, leverage and market ratios. Each one of them has its different relevance and
purposes and may be applied and analysed depending on the decision to be made.
Besides the advantages, the financial ratios do suffer from some limitations as well, some of which are:
1. They are relative and depends upon company to company and from industry to industry. A ratio
which may be positive from the perspective of one industry may not be relevant or positive
from the perspective of another industry (Jefferson, 2017).
2. They ignore the level of inflation or the price changes which do occur over the period of time
and hence gives rise to inconsistency.
3. Financial Ratios indicate only the quantitative aspect of the company and ignore all the
qualitative aspects of the company hence it is narrower in view.
4. They do not tend to solve the actual problems of the company and therefore, they are just the
means to the end and not the final solution (Linden & Freeman, 2017).
5. The financial ratios may be changed towards the year end and hence they are not consistent
over the year and may end in window dressing.
Commonly Used Ratios
Some of the commonly used financial ratios being used by the investors are:
1. Price Ratios: Price to Earnings Ratio, PEG Ratio, Price to Sales Ratio, Price to Book Ratio, Dividend
Yield, Dividend Pay-out Ratio.
2. Profitability Ratios: Return on Assets, return on equity, Profit margin
3. Liquidity Ratios: Current Ratio, Quick Ratio (Heminway, 2017)
4. Debt Ratios: Debt to Equity Ratio Interest Coverage Ratio
5. Efficiency Ratios: Asset Turnover Ratio, Inventory Turnover Ratio
Different Financial Ratio
Some of the most important and critical financial ratios which is being analysed in case of any and every
company has been shown below:
1. Gross Profit Ratio: It is one of the profitability ratios and indicates the gross profit being earned
by the company as a percentage of the total sales of the company. The same is calculated by
dividing the gross profit by net sales of the company. Gross profit is represented as sales less
cost of goods sold and cost of goods sold comprises of the material cost, the labour costs and
the overheads (Dichev, 2017).
Mathematically, Gross Profit ratio = (Gross Profit / Net Sales *100)
It represents what is the proportion of the direct cost which is expended by the company to
achieve the sales and indicates how the cost can be saved.
2. Net Profit Ratio: It is again one of the other measures of profitability and indicates the net profit
being earned by the company as a proportion of the sales. It is calculated as net profit divided by
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net sales of the company. Net profit is gross profit less indirect expenses. The indirect expenses
include general and administrative expenses, the selling and distribution expenses and the
finance expenses (Bromwich & Scapens, 2016).
Mathematically, Net profit ratio = (Net Profit / Net Sales * 100)
It is representative of the fact as to what is the proportion of indirect expenses in the overall
expenses of the company and how the same can be optimised or minimised. It shows that
whether the company has been growing in terms of profitability or is declining in terms of
performance.
3. Current Ratio: The current ratio is a measure of the liquidity of the company and shows if the
company will be able to meet the short term obligations on time if at all is warranted. It is
calculated as sum of current assets divided by sum of current liabilities. It shows the ability of
the company to meet the short term or current liabilities on time and indicates if there is excess
of current asset or the shortage of the same.
Mathematically, Current Ratio = Current Assets/Current Liabilities.
The ideal current ratio is 2 times as it is believed that if the company holds 2 times current
assets of current liabilities, then there are less chances of default and the credibility of the
company increases. Current asset is mainly inclusive of inventory, receivables, cash and cash
equivalents, prepaid expenses and current liabilities includes trade payables, provisions,
outstanding expenses.
4. Liquidity Ratio: The liquidity ratios shows if the company possesses adequate liquidity for
meeting the short term payment obligations. The liquid ratio is calculated as liquid assets
divided by the current liabilities. It shows the ability of the company to pay off the debts
immediately in case the company is asked to wind up (Belton, 2017).
Mathematically, liquid ration = liquid Assets / Current Liabilities
Liquid assets is current assets less inventory or stock and the prepaid expenses. These two are
not considered as liquid assets as they are not readily convertible to cash. Current liabilities
includes trade payables, provisions and outstanding expenses. The ideal liquid ratio is 1 times
and may further fluctuate depending on company to company.
5. Return on investment: It is the ratio of the net profit and the cost of the investment when there
is an investment by the company in the form of some resources. The ratio aims to evaluate the
efficiency of the investment and then compare the same with several other alternatives as well
so as to decide which one of the all is the most efficient one. It is expressed as a percentage and
is one of the most important and critical measure of evaluation of any investment.
Mathematically, return on investment = (Income from Investment - Cost of Investment) / Cost of
Investment. For example, a person invests in the securities at the beginning of the year $1000
and then sold the investments at $ 1200 a year later. So, the net income or the profit accruing to
him is $ 200 and the return on investment in such a case would be 200/1000 = 20%. The
investment can be said to be good if the return on investment is greater than 0%.
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Conclusion
From the above discussion and analysis on the ratios, we came to know that the ratios play a pivotal role
in the financial analysis and have a key role to play in the decision making as well. We also found out
that there may be different types of ratios and the same may be applied depending on the situation and
circumstances of the case. Amongst all, the financial ratios are the one which help the investors in
decision making as to invest in the particular security or not. Some of the critical ratios being analysed
above along with their use and the formula include the gross profit ratio, the net profit ratio, current
ratio, liquid ratio and the return on investment.
References
Alexander, F. (2016). The Changing Face of Accountability. The Journal of Higher Education, 71(4), 411-
431.
Belton, P. (2017). Competitive Strategy: Creating and Sustaining Superior Performance (Vol. 2). London:
Macat International ltd.
Bromwich, M., & Scapens, R. (2016). Management Accounting Research: 25 years on. Management
Accounting Research, 31(1), 1-9.
Choy, Y. K. (2018). Cost-benefit Analysis, Values, Wellbeing and Ethics: An Indigenous Worldview
Analysis. Ecological Economics, 145. Retrieved from
https://doi.org/10.1016/j.ecolecon.2017.08.005
Dichev, I. (2017). On the conceptual foundations of financial reporting. Accounting and Business
Research, 47(6), 617-632. doi:https://doi.org/10.1080/00014788.2017.1299620
Goldmann, K. (2016). Financial Liquidity and Profitability Management in Practice of Polish Business.
Financial Environment and Business Development, 4(3), 103-112.
Heminway, J. (2017). Shareholder Wealth Maximization as a Function of Statutes, Decisional Law, and
Organic Documents. SSRN, 1-35.
Jefferson, M. (2017). Energy, Complexity and Wealth Maximization, R. Ayres. Springer, Switzerland .
Technological Forecasting and Social Change, 353-354.
Linden, B., & Freeman, R. (2017). Profit and Other Values: Thick Evaluation in Decision Making. Business
Ethics Quarterly, 27(3), 353-379. Retrieved from https://doi.org/10.1017/beq.2017.1
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