Financial Statement Review Using Ratio Analysis of DSE
Although a glance at the financial statements may highlight areas of concern, it is often difficult to interpret all of the information presented on these statements. For example, knowing that there is a large amount of inventory in the warehouse is not as helpful as knowing how quickly the company is turning over its inventory compared to others in the industry (i.e., use of the inventory turnover ratio). Ratios have been developed to provide a comprehensive way to absorb the data disclosed on financial statements. Ratios, in general, involve a process of standardization.
Ratios measure a firm's crucial relationships by relating inputs (costs) with outputs (benefits) and facilitate comparisons of these relationships over time and across firms. Traditional ratio analysis provides insightful information to the analyst by summarizing data from financial statements and placing it into an easily understood format.
The easiest job the analyst will have is calculating the ratios. The availability of financial analysis packages and computerized databases permit the analyst to do much of the analytical work on the computer. The important and challenging part of the analysis is the interpretation of the results. These interpretations require the analyst to understand the reason for the analysis, to identify the current conditions facing the industry, and to understand the important accounting principles underlying the financial statements.
The analyst can perform two different forms of ratio analysis: time-series analysis (comparing ratios for the same firm over time) and cross-section analysis (comparing ratios for the same period with other firms in the industry). A time series analysis of a particular firm’s financial statement ratios permits a historical tracking of the trends and variability in the ratios over time. The analyst can study the impact of economic conditions (i.e., recession or inflation), industry conditions (e.g., shift in regulatory status, new technology), and firm-specific conditions (e.g., shift in corporate strategy, new management) on the time pattern of these ratios.
Using cross-sectional analysis, the analyst can make comparisons between the contractor being analyzed and other related firms. The analyst needs to be very selective when identifying the firms with which to compare. The analyst should select firms with similar products, strategies, and size. Also, the analyst must keep in mind differences in accounting methods, operations, financing, etc. Since this is often difficult, a common approach is to use average industry ratios as benchmarks.
Industry norms may be calculated directly through the use of computerized databases such as Standard & Poor's CompuStat Database. Alternatively, industry profiles are available from sources such as Robert Morris Associates (RMA) and Dun & Bradstreet's (D&B) Industrial Handbook. These sources provide common-size balance sheets, income statements, and selected ratios on an industry and company basis.
The broad categories of analysis that measure such relationships are listed below:
- Liquidity Analysis measures the adequacy of a firm's cash resources to meet its near-term cash obligations.
- Current Ratio
- Quick Ratio
- Cash Ratio
- Cash Flow From Operations Ratio
- Net Working Capital to Total Assets Ratio
- Asset Utilization Analysis evaluates the levels of output generated by the assets employed by the firm.
Total Asset Turnover Ratio
- Fixed Assets Turnover Ratio
- Inventory Turnover Ratio
- Average Number of days inventory in stock
- Receivables Turnover Ratio
- Average Number of days Receivables are outstanding
Profitability Analysis measures the net income of the firm relative to its revenues and capital investments.
- Gross Profit Margin Ratio
- Net Profit Margin Ratio
- Basic Earning Power Ratio
- Return on Assets Ratio
- Return on Equity Ratio
Debt Utilization Analysis examines the firm's capital structure in terms of the mix of its financing sources and the ability of the firm to satisfy its longer-term debt and investment obligations. Ratios:
- Debt to Equity Ratio
- Total Debt to Total Assets Ratio
- Times Interest Earned Ratio
- Debt to Total Capital Ratio
As will become apparent in the discussions that follow, the categories are not distinct but rather interrelated. Thus, profitability affects solvency, and the efficiency with which assets are used (as measured by asset utilization analysis) impacts the analysis of profitability. In measuring these relationships, ratios provide a profile of a contractor. An analysis of the ratios can provide insight into a contractor’s performance, economic characteristics, competitive strategies, and abilities. Formulas for ratios are included as Appendix 4D.
Ratio analysis should be fairly comprehensive. Each ratio included in this chapter will assist the analyst in focusing on a particular aspect of the firm. At times, a full analysis is not possible due to time constraints or limited information. In this case, a "condensed" ratio analysis can be applied. Appendix 4E supplies ratios that should be used when only performing a limited analysis.
Common measures of market performance:
There are four indicators of market performance:
- Market Capitalization
- Value Turnover
- Traded Volume