Ratio Analysis

In order to assess a company, most people immediately look at its profit history. While this is one of the indicators that should be considered, it could be a mistake to make a decision based solely on that information. As we saw in Chapter 7, Cash Flow Statement, profits do not always equate to cash, and even the most profitable company can fold if the profits are not backed up by cash flow.

Ratio analysis looks at the profitability, liquidity, asset management and efficiency, debt management, and market value of a company. Each ratio takes two strategic items from financial statements and examines the relationship between them in order to gain some insight into the company's profitability, liquidity, and so on.

In this chapter, we will cover the following topics:

• Understanding the meaning and benefits of ratio analysis
• Learning about the various kinds of...

Understanding the meaning and benefits of ratio analysis

A ratio is calculated by dividing one item by another—for example, profit divided by turnover. However, you should not pick items from financial statements at random and divide them; you should select items whose ratio will be meaningful and provide information that will aid decision-making. In the example of profit divided by turnover, this ratio, otherwise called the profit margin, tells you how much profit is generated for every Naira of turnover.

Ratios are usually expressed as percentages, but also as percentages as they apply to times or days. A profit margin of 20% means that after all relevant deductions, the company retains 20% of its turnover as profit. In other words, the profit for the period is 20% of the turnover. The ratios on their own are useful in directing the attention of management and section...

Learning about the various kinds of ratios

There are thousands of ratios, and you could easily get carried away with them. To make life easier for us, ratios can be classified under five broad categories—namely, profitability, liquidity, efficiency, debt management, and market ratios.

We will examine a few examples for each of these categories.

These ratios measure how capable a company is of converting turnover into profit. These ratios are usually referred to as the margin, which generally means that they are divided by turnover. Let's look at the gross profit margin, which is expressed as the following formula:

Here, the gross profit is the turnover less the cost of sales.

Sometimes, when a company makes a loss, you can still take some comfort if there is a gross profit. This means that the direct costs have been covered and there is some contribution towards...

Interpreting ratios

The investors and other external interest groups of a company usually only have access to the financial statements of the company. However, financial details alone are of limited use when trying to assess a company. Ratios are a valuable tool for such interest groups, giving them the opportunity to assess companies in a standardized manner using widely accepted parameters.

It is usually a very subjective process to try and compare companies of different sizes, geographical locations, fiscal jurisdictions, and nature. Ratio analysis provides a level playing field by laying emphasis on performance rather than absolute size of turnover or profit. Efficiency, profitability, and liquidity are more or less independent of the absolute size of the individual parameters involved, such as turnover, assets, profit, and liabilities.

Ratio analysis allows the comparison...

Understanding the limitations of ratio analysis

It is important to realize that ratios do not actually solve any problems; they merely highlight trends and exceptions that can then be acted upon. Definitions of ratios often vary from one analyst to another—for example, the quick ratio and the acid test. Some analysts refer to the ratio of current assets minus inventory divided by current liabilities as the quick ratio, while others refer to the same ratio as the acid test.

One school of thought uses the year-end balances for assets in ROA and equity and long-term debt in ROACE. Another school of thought recognizes that companies can manipulate this ratio by posting significant transactions at the year end, only to reverse them in the new year. They therefore use the average of those balances that will counter such practices. These differences in approach can lead to vastly...

Using ratios to find financially stable companies

Let's assume that you are looking to invest in a company that is financially stable and has a good market value. We can find out the best company for this using the following ratios:

• EPS: This can be useful ratio for finding the best company to invest in because it shows you how much money the company makes as profit for each share that the company sells
• P/E ratio: This ratio tells you that there might be more growth in the future of the company, and it also shows you how much an investor is willing to pay for a share

We will go through the following steps to use these ratios:

1. Open the CompanyInvestment.xlsx file, where you will find details about some companies, such as their PAT, number of shares, and the market price of each share, as shown in the following screenshot:

2. Now, we will calculate the EPS for each company...

Summary

In this chapter, we have learned about the importance of ratio analysis. We have seen that there are thousands of ratios, but we have learned that not all will be relevant in any given situation. We looked at how to identify the five main groups of ratios and worked through examples from all five groups.

In the next chapter, we will look at absolute (by discounted cash flow) and relative (by comparative measurements) methods of valuation. We will cover the concept of the time value of money and use it extensively in our calculations. We will learn about several concepts, including free cash flow, the weighted average cost of capital, and terminal value, among others.