Basics of Ratio analysis and leverage

Introduction:

It can be safe to believe that accounting can be tracked back to the days when money was introduced as a medium of exchange in business transactions. There are various sources of ancient literature that support recording of business transactions as early as 7500 BC in the Mesopotamian civilization[1]. Luca Pacioli has been regarded as the father of the modern-day accounting as most of the accounting practices of today was portrayed in his in his book Summa de Arithmetica, Geometria, Proportioni et Proportionalita (Everything About Arithmetic, Geometry and Proportions) as early as 1494[2]. With the growth of complexities and the size of business accounting has also been continuously been evolving along with the nature of business and in order to full fill its purpose. In todays’ scenario accounting is not seen as a mere recording of business transactions but its purpose extends up to the stages of making crucial decisions in the business. It is also used by various individuals and entities to analyse various aspect of the companies and to compare their performance against their peers and the industry. It is also important to note that for a publicly listed companies in majority of developed and developing countries, it is a mandatory requirement for them to audit their financial statement at regular intervals as per the law. Generally, every company is to audit their accounts at least once in year. Therefore, accounting as has come a long from being just a record of transactions to being able to provide a true and fair picture of the financials of the company if practiced effectively.

In present days a company’s financial health is analyzed by using the financial statements which are prepared as a part of accounting process. Financial statements comprise of i. Statement of Profit/Loss or Income statement of the company which brings out the information of the operational activities of the company for a particular time frame. ii. Balance sheet, is built upon the accounting equation Assets is the sum of Liabilities and Owner’s equity. The balance sheet of a company portrays the details of what the company owns and what the company owes. Balance sheet bring out some of the very crucial information about the company which will be used for analysis. iii. Statement of Cash flows shows the movement of cash inflow and outflow in the company this information is vital in understanding the sources and uses of cash and gives a broader understanding about the activities of the company. In this research the author has brought out the Key Performance Indicators (KPIs) of the financial health of a company which can be obtained from the financial statements of the company and their implications.

Major indicators of financial health of a company implemented in this study:

In order to analyse the Financials of a company the following measures can be applied to identify the trends in the financials of the companies.

1. Ratio analysis:

Ratio analysis is one of the simplest and effective measure of financial strength of a company’s financial statements. There are various ratios, however, in this study the Key ratios that were analyzed were i. Liquidity ratio, ii. Activity ratio, iii. Ownership ratio, iv. Profitability ratio and v. Operating ratio.

• Liquidity ratio:

1. Current ratio: It gives the ratio between the current assets of a company to the current liabilities of the company. This ratio brings very significance reference to the effectiveness of the company in meeting its short-term payments and in carry out the day to day operations of the company. The ideal current ratio is recommended to be 2:1, however these recommended figures are expected to change from industry to industry and it also depends greatly on the nature of the business.
2. Liquid ratio (acid test): It can be understood as a variant of the current ratio. Liquid ratio gives the ratio between Cash, Trade receivables and marketable securities over the current liability of the company. It is denoted as an acid test ratio because it portrays the ability of the company in meeting its unexpected short-term expenses. The ideal bench mark of an acid test is recommended to be 1:1.

• Activity ratio:

1. Accounts receivable turnover ratio: It is also known as “Debtors turnover ratio”, it gives count of average account receivable collected by the company over a given period. It is calculated by dividing the net credit sale for the period by average accounts receivable i.e {(AR in beginning + AR at the close)/2}. This ratio also helps in calculation of AR turnover in Days, which gives us the approximate number of days the consumers take to pay their debt to the company. It is calculated by dividing 365 by the AR turnover ratio. A higher turnover ratio means the company is efficient in collecting its debts and the there is also average time taken by the consumers in re-payment of debt to the company is less.
2. Inventory turnover ratio: This ratio brings the number of times the company has managed to convert its average inventory to sale. It is calculated by dividing the annual sale by average inventory i.e {(Opening inventory + Closing inventory)/2}. The idea behind opting for average inventory over of closing inventory is because the company’s inventory value tends to be fluctuating over the period. A higher inventory turnover shows that the company is very effective in converting its inventory to cash and the liquidity of the company is not hampered due to the inventory the company holds however, a higher turnover can also mean that the company is not having enough inventory in place to meet its demands. While a lower inventory turn over indicates that the company requires more time to convert the inventory to sales or it could have its working capital locked up as inventory. It should also be noted of all the current assets inventory is the least liquid and it also suffers from the risk of fall in demand and change in consumer preference.
3. Asset turnover ratio: It brings the efficiency with which the company uses its assets. It is calculated by dividing the net sales by Total assets of the company. A higher ratio indicated the company is using the assets effectively in generating its revenue.

• Ownership ratio:

1. Debt – Equity ratio: As the name suggests this ratio brings the proportion of debt to the equity in the capital structure of the company. A higher ratio states that the company is highly leveraged by employing more debt in its capital structure. Higher debit in a company’s capital structure also requires the company to make periodic payment for the debt employed any default in these payments may lead to lenders filing for bankruptcy. On the other hand, a low Debit-Equity ratio   indicates that the company has very less debt in its capital structure and the risk of default is less. However, it should also be noted that the company is not utilizing the cheaper source of capital. In order to calculate the ratio Total liability of the company is divided by total share holder equity of the company.
2. Debt ratio: It the proportion assets financed through the short- and long-term debts of the firms. It is calculated by dividing the total debt of the company by total assets of the company. A higher ratio indicates that the firm is highly leveraged, and a substantial portion of the assets is funded by debt.

• Profitability ratio:

1. Gross profit ratio: The percentage of Gross profit to sales is represented in this ratio. A higher gross profit ratio indicates that the company has manages its direct cost efficiently and can make good profits if it controls its indirect and over head costs. It is calculated by dividing the gross profit by sales and multiplying by 100 in order to arrive at the percentage.
2. Net profit ratio: Like Gross profit ratio Net profit ratio provides the percentage of Net profit over the total sales of the company. A high Net profit ratio indicates the efficiency of management and ability of the company to keep the overall cost in control. Net profit divided by total sales gives the Net profit ratio of the company.
3. Return on Equity (RoE): Net income of the company divided by Total shareholder’s equity gives the Return on Share holders equity. This ratio is also expressed as a percentage. This ratio is generally compared with the industry bench mark to analyse the company’s financial performance over the period.
4. Return on Capital employed: This ratio is very close to RoE discussed above, in this ratio the entire capital employed by the company inclusive of debt capital is considered along with the Equity and reserves. It helps in analyzing the overall effective use of the capital by the company.

• Leverage
  • Operational Leverage:  It brings the relative change in Earnings before Income and Tax (EBIT) to a change in Net sales. A company with high fixed operational cost tends to be leveraged operationally and a small change in the sales will have a magnifying effect on EBIT of the company. Capital intensive companies generally incur higher level of fixed cost compared to a labor driven company. Degree of operational leverage is calculated by dividing the contribution of the company by EBIT (Sum of Net income, Interest and taxes). A company highly levered is faced with the risk of cash flow problems during times of economic slow down as a small fall in sale brings a magnified fall in EBIT of the company. Degree of Operational leverage can also be considered as a proxy of the firm’s business risk as it magnifies the effect of sales in the EBIT of the firm.
  • Financial Leverage: Infusion of debt in the capital structure of a company is termed as financial leverage. Degree of financial leverage portraysthe relationship between EBIT and Earnings per Share (EPS). A high degree of financial leverage shows that a small degree of change in EBIT has a magnified effect of EPS. Degree of financial leverage is calculated by dividing the relative change in EPS by change in EBIT of the company. A high degree of financial leverage shows that the company has higher composition of Debt or fixed cost capital in its capital structure which demands regular cash flows in order to pay the interest expenses incurred on the fixed cost capital employed by the company failure to do so may lead to catastrophic results for the company.
  • Combined leverage: Combined leverage is applicable when the company used both operational and financial leverage in order to magnify the effect of change in sales on the EPS. Combined leverage is the product of operational and financial leverage. Combined leverage can also be calculated by dividing the contribution by Profit earned before tax. The degree of combined leverage portrays the relative change in EPS to the change in the volume of sales.

Operational leverage shows the degree at which the firm is incurring fixed cost to its total operating costs at various sales levels. Operational leverage magnified the impact of change in sales on the EBIT of the company. Financial leverage evaluates the changes in Net income of the company to the changes its net operating income. It can be stated that a firm’s operational leverage is a result of the company’s choice of technology i.e fixed or variable cost while the financial leverage is depended on the company’s capital mix i.e mix of debt and equity capital.

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[1] Andre. (2017). A BRIEF HISTORY OF ACCOUNTING: WHERE DID IT START? https://babington.co.uk/blog/accounting/brief-history-of-accounting/ (Retrieved on 07 Jan 2019)

[2] Smith, Murphy. (2013). Luca Pacioli: The Father of Accounting. SSRN Electronic Journal. 10.2139/ssrn.2320658.