Forecasting is one of the fundamental financial functions, a financial system can take various forms. However, it is essential that it takes into account the strengths and weaknesses of the company. For example, the company that expects to have an increase in its sales, is it in a position to bear the financial impact of this increase? On the other hand, is your debt profitable? How can the bankers who must make decisions in granting loans to companies support their decisions?
The objective of this work is to present the advantages and applications of the analysis of financial statements with ratios or indices. These indices use two important financial statements in their analysis: the Balance Sheet and the Profit and Loss Statement, in which the economic and financial movements of the company are recorded. They are almost always prepared, at the end of the period of operations and in which the capacity of the company to generate favorable flows is evaluated according to the compilation of accounting data derived from economic events.
To explain our scheme, we will use as a model the financial statements of the WHOLESALE DISTRIBUTOR COMPANY OF FERTILIZERS AND CHEMICAL PRODUCTS OF PERU DISTMAFERQUI SAC., In the period 2003 - 2004. For the application of the ratios we operate with the figures of the year 2004 and when we need average we operate with the figures for 2003 and 2004.
At the end of the chapter we insert a table showing the evolution of the indicators in the period from 2003 to 2004 and the Return on Invested Capital DU-PONT Matrix. In this work we use the terms Social Capital or Patrimony as synonyms.
2. The Ratios
Mathematically, a ratio is a ratio, that is, the relationship between two numbers. They are a set of indices, the result of relating two accounts of the Balance Sheet or of the Profit and Loss statement. Ratios provide information that allows those interested in the company to make the right decisions, be they its owners, bankers, advisors, trainers, the government, etc. For example, if we compare current assets with current liabilities, we will know what the company's payment capacity is and whether it is sufficient to respond for the obligations contracted with third parties.
They serve to determine the magnitude and direction of the changes suffered in the company during a period of time. The ratios are basically divided into 4 large groups:
2.1. Liquidity indices. They evaluate the company's ability to meet its short-term commitments.
2.2. Management or activity indices. They measure the use of assets and compare the sales figure with the total assets, property, plant and equipment, current assets or elements that make them up.
2.3. Solvency, indebtedness or leverage indices. Ratios that relate resources and commitments.
2.4. Profitability Indices. They measure the ability of the company to generate wealth (economic and financial profitability).
3. The Analysis
A. Liquidity Analysis
They measure the ability to pay that the company has to face its short-term debts. That is, the cash available to pay off debts. They express not only the management of the company's total finances, but the managerial ability to convert certain current assets and liabilities into cash. They facilitate examining the financial situation of the company compared to others, in this case the ratios are limited to the analysis of current assets and liabilities.
A good image and position in front of financial intermediaries requires: maintaining a sufficient level of working capital to carry out the operations that are necessary to generate a surplus that allows the company to continue its activity normally and to produce enough money to pay off the needs for financial expenses that your debt structure demands in the short term. These ratios are four:
1a) General liquidity ratio or current ratio
The general liquidity ratio is obtained by dividing current assets by current liabilities. Current assets basically include cash accounts, banks, accounts and bills receivable, easily negotiable securities and inventories. This ratio is the main measure of liquidity, it shows what proportion of short-term debts are covered by assets, whose conversion into money corresponds approximately to the maturity of the debts.
For DISTMAFERQUI SAC, the general liquidity ratio in 2004 is:
This means that current assets are 2.72 times larger than current liabilities; or that for each MU of debt, the company has MU 2.72 to pay it. The higher the value of this ratio, the greater the company's ability to pay its debts.
2a) Acid test ratio
It is that indicator that by discarding accounts that are not easily realizable from current assets, provides a more demanding measure of a company's ability to pay in the short term. It is somewhat more severe than the previous one and is calculated by subtracting the inventory from current assets and dividing this difference by current liabilities. Inventories are excluded from the analysis because they are the least liquid assets and the most subject to losses in the event of bankruptcy.
The acid test for 2004, in DISTMAFERQUI SAC is:
Unlike the previous reason, this one excludes inventories as they are considered the least liquid part in the event of bankruptcy. This ratio focuses on the most liquid assets, thus providing more correct data to the analyst.
3a) Defensive test ratio
It allows to measure the effective capacity of the company in the short term; It only considers the assets held in Caja-Bancos and the marketable securities, ruling out the influence of the time variable and the uncertainty of the prices of the other current asset accounts. It indicates the company's ability to operate with its most liquid assets, without resorting to its sales flows. We calculate this ratio by dividing the total of cash and bank balances by current liabilities.
In DISTMAFERQUI SAC for 2004, we have:
That is, we have 21.56% of liquidity to operate without resorting to sales flows
4a) Working capital ratio
As it is used frequently, we are going to define it as a relationship between Current Assets and Current Liabilities; it is not a ratio defined in terms of one item divided by another. The Working Capital is what remains for the firm after paying its immediate debts, it is the difference between the Current Assets minus Current Liabilities; something like the money you have left to operate on a day-to-day basis.
The value of the working capital in DISTMAFERQUI SAC in 2004 is:
In our case, it is indicating that we have the economic capacity to respond to obligations with third parties.
Important remark:
To say that the liquidity of a company is 3, 4 times more does not mean anything. To this mathematical result it is necessary to give economic content.
5a) Liquidity ratios of accounts receivable
Accounts receivable are liquid assets only to the extent that they can be collected in a reasonable time.
Basic reasons:
For DISTMAFERQUI SAC., This ratio is:
The index is showing us that the accounts receivable are circulating for 61 days, that is, it indicates the average time it takes to convert them into cash.
For DISTMAFERQUI SAC., This ratio is:
The reasons (5 and 6) are reciprocal of each other. If we divide the average collection period by 360 days in the commercial or banking year, we will obtain the turnover of accounts receivable 5.89 times a year. Likewise, the number of days in the year divided by the turnover rate of accounts receivable gives us the average collection period. We can use these ratios interchangeably.
B. Analysis of the Management or activity
They measure the effectiveness and efficiency of management, in the administration of working capital, express the effects of decisions and policies followed by the company, with respect to the use of its funds. They show how the company was managed in terms of collections, cash sales, inventories and total sales. These ratios imply a comparison between sales and assets necessary to support the level of sales, considering that there is an appropriate value of correspondence between these concepts.
They express how quickly accounts receivable or inventories are converted to cash. They are a complement to the liquidity reasons, since they allow to specify approximately the period of time that the respective account (account receivable, inventory), needs to be converted into money. They measure the ability of management to generate internal funds, by properly managing the resources invested in these assets. Thus we have in this group the following ratios:
1b) Portfolio turnover ratio (accounts receivable)
They measure the frequency of recovery of accounts receivable. The purpose of this ratio is to measure the average term of loans granted to clients and to evaluate the credit and collection policy. The balance in accounts receivable must not exceed the sales volume. When this balance is greater than sales, the total immobilization of funds in accounts receivable occurs, subtracting the company, payment capacity and loss of purchasing power.
It is desirable that the balance of accounts receivable rotate reasonably, in such a way that it does not imply very high financial costs and that it allows using credit as a sales strategy.
Collection period or annual rotation :
It can be calculated by expressing the average days that accounts remain before being collected or by indicating the number of times that accounts receivable rotate. To convert the number of days into the number of times that accounts receivable are immobilized, we divide by 360 days in a year.
Collection period:
For DISTMAFERQUI SAC in 2004 we have:
Annual rotation:
This means that the company converts its accounts receivable into cash in 63.97 days or they rotate 5.63 times in the period.
The rotation of the portfolio a high number of times is an indicator of a successful credit policy that prevents the immobilization of funds in accounts receivable. Generally, the optimal level of portfolio turnover is 6 to 12 times a year, 60 to 30 days of collection period.
2b) Inventory Rotation
It quantifies the time it takes for the investment in inventories to become cash and allows to know the number of times this investment goes to the market, in a year and how many times it is replenished.
There are several types of inventories. An industry that transforms raw materials will have three types of inventories: that of raw materials, that of products in process and that of finished products. If the company is engaged in commerce, there will be only one type of inventory, called accounting, as merchandise.
Period of inventory immobilization or annual turnover:
The number of days that remain immobilized or the number of times that inventories rotate in the year. To convert the number of days into the number of times that the investment held in finished products goes to market, we divide by 360 days in a year.
Inventory immobilization period:
We can also measure it in two ways, taking DISTMAFERQUI SAC as an example in 2004:
Annual rotation:
This means that inventories go to the market every 172 days, which shows a low turnover of this investment, in our case 2.09 times a year. The higher the turnover, the greater the mobility of the capital invested in inventories and the faster recovery of the profit that each unit of finished product has. To calculate the inventory turnover of raw material, finished product and in process, proceed in the same way.
We can also calculate INVENTORY ROTATION, as an indication of inventory liquidity.
It tells us how quickly inventory changes in accounts receivable through sales. The higher the inventory turnover, the more efficient a company's inventory management will be.
3b) Average period of payment to suppliers
This is another indicator that allows obtaining indications of the behavior of working capital. It specifically measures the number of days that the signature takes to pay the credits that the providers have granted.
A common practice is to seek that the number of pay days is greater, although care must be taken not to affect your image of "good pay" with your raw material suppliers. In inflationary times, part of the loss of purchasing power of money must be discharged from suppliers, buying from them on credit.
Payment period or annual turnover : In a similar way to the previous ratios, this index can be calculated as average days or rotations per year to pay debts.
Annual rotation:
We must interpret the results of this ratio in the opposite way to those of accounts receivable and inventories. Ideally, get a slow ratio (ie 1, 2 or 4 times a year) as it means that we are making the most of the credit offered by your raw material suppliers. Our ratio is very high.
4b) Cash and bank turnover
They give an idea about the size of the cash and banks to cover days of sale. We obtain it by multiplying the total of Cash and Banks by 360 (days of the year) and dividing the product by the annual sales.
For DISTMAFERQUI SAC in 2004, we have:
Interpreting the ratio, we will say that we have liquidity to cover 16 days of sale.
5b) Total Asset Turnover
Ratio that aims to measure the sales activity of the firm. In other words, how many times can the company place a value equal to the investment made among its clients.
To obtain it, we divide the net sales by the value of the total assets:
For DISTMAFERQUI SAC in 2004, we have:
In other words, our company is placing 1.23 times the value of the investment made among its clients.
This relationship indicates how productive the assets are to generate sales, that is, how much sales are being generated for each MU invested. It tells us how productive the assets are to generate sales, that is, how much more we sell for each MU invested.
6b) Rotation of Fixed Assets
This ratio is similar to the previous one, with the aggregate that measures the company's ability to use capital in fixed assets. It measures the sales activity of the company. It says, how many times can we place between clients a value equal to the investment made in fixed assets.
For DISTMAFERQUI SAC in 2004 it results:
In other words, we are placing 5.40 times the value of what is invested in fixed assets in the market.
C. Analysis of solvency, indebtedness or leverage
These ratios show the amount of resources that are obtained from third parties for the business. They express the support that the company has against its total debts. They give an idea of the financial autonomy of it. They combine short-term and long-term debt.
They allow knowing how stable or consolidated the company is in terms of the composition of the liabilities and their relative weight with the capital and equity. They also measure the risk of who offers additional financing to a company and also determine who has contributed the funds invested in the assets. Shows the percentage of total funds contributed by the owner (s) or creditors either in the short or medium term.
For the financial institution, the important thing is to establish standards with which it can measure the indebtedness and then be able to speak of a high or low percentage. The analyst must be clear that indebtedness is a cash flow problem and that the risk of going into debt consists of the ability that the company's management has or does not have to generate the necessary and sufficient funds to pay the debts as they go overcoming.
1c) Capital structure (equity debt)
It is the quotient that shows the degree of indebtedness in relation to equity. This ratio evaluates the impact of the total liability in relation to equity.
We calculate it by dividing the total liability by the equity value:
For DISTMAFERQUI SAC in 2004, we have:
This means that for each MU contributed by the owner (s), there is MU 0.81 cents or 81% contributed by creditors.
2c) Indebtedness
Represents the percentage of funds of participation of creditors, either in the short or long term, in the assets. In this case, the objective is to measure the overall level of indebtedness or proportion of funds contributed by creditors.
Illustrating the case of DISTMAFERQUI SAC in 2004, we have:
In other words, in our company analyzed for 2004, 44.77% of total assets are financed by creditors and if these total assets are settled at the book price, a balance of 55.23% of their value would remain, after the payment of current obligations..
3c) Coverage of financial expenses
This ratio tells us to what extent profits can decrease without putting the company in a difficult situation to pay its financial expenses.
For DISTMAFERQUI SAC in 2004, we have:
One way to measure it is by applying this ratio, the result of which projects an idea of the applicant's ability to pay.
It is an indicator used very frequently by financial institutions, since it allows to know how easy it is for the company to meet its obligations derived from its debt.
4c) Coverage for fixed expenses
This ratio allows to visualize the survival capacity, indebtedness and also to measure the capacity of the company to assume its fixed cost burden. To calculate it, we divide the gross margin by the fixed expenses. The gross margin is the only possibility that the company has to respond for its fixed costs and for any additional expenses, such as financial expenses.
Applying to our example we have:
In this case, we consider as fixed expenses the items of sales, general and administrative expenses and depreciation. This does not mean that selling expenses necessarily correspond to fixed expenses. When classifying fixed and variable costs, the particularities of each company should be analyzed.
D. Profitability Analysis
They measure the ability to generate profit by the company. Their objective is to appreciate the net result obtained from certain decisions and policies in the administration of the company's funds. They evaluate the economic results of business activity.
They express the performance of the company in relation to its sales, assets or capital. It is important to know these figures, since the company needs to produce a profit in order to exist. They directly relate the ability to generate funds in short-term operations.
Negative indicators express the phase of decumulation that the company is going through and that will affect its entire structure by demanding higher financial costs or a greater effort from the owners to maintain the business.
The profitability indicators are very varied, the most important and which we study here are: profitability on equity, profitability on total assets and net margin on sales.
1d) Return on equity
We obtain this ratio by dividing the net profit by the net worth of the company. It measures the profitability of the funds contributed by the investor.
For DISTMAFERQUI SAC in 2004, we have:
This means that for each MU that the owner maintains in 2004 generates a return of 3.25% on equity. That is, it measures the ability of the company to generate profit for the owner.
2d) Return on investment
We obtain it by dividing the net profit by the total assets of the company, to establish the total effectiveness of the administration and produce profits on the total assets available. It is a measure of the profitability of the business as a project independent of the shareholders.
For DISTMAFERQUI SAC in 2004, we have:
This means that each MU invested in assets in 2004 produced a 1.79% return on investment that year. High indicators express a higher return on sales and money invested.
3d) Active profit
This ratio indicates the efficiency in the use of a company's assets, we calculate it by dividing earnings before interest and taxes by the amount of assets.
It is indicating that the company generates a profit of 12.30% for each MU invested in its assets
4d) Sales profit
This ratio expresses the profit obtained by the company, for each MU of sales. We obtain this by dividing the profit before interest and taxes by the value of assets.
In other words, for each MU sold we have obtained 10.01% as a profit in 2004.
5d) Earnings per share
Ratio used to determine net earnings per common share.
For DISTMAFERQUI SAC in 2004, we have:
This ratio is telling us that the profit for each common share was CU 0.7616.
6d) Gross and net profit margin
Gross margin
This ratio relates sales less cost of sales to sales. Indicates the amount of profit obtained for each MU of sales, after the company has covered the cost of the goods it produces and / or sells.
Indicates earnings relative to sales, less production costs of goods sold. It also tells us the efficiency of operations and the way in which product prices are assigned.
The higher the gross profit margin, the better, as it means that you have a low cost of the goods you produce and / or sell.
Net margin
Profitability more specific than the previous one. Relate net income to the level of net sales. It measures the percentage of each sales MU that remains after all expenses, including taxes, have been deducted.
The larger the company's net margin, the better.
For DISTMAFERQUI SAC in 2004, we have:
This means that in 2004, for each MU that the company sold, it obtained a profit of 1.46%. This ratio makes it possible to evaluate whether the effort made in the operation during the analysis period is producing an adequate remuneration for the employer.
3.1. DU - PONT analysis
To explain, for example, the low net sales margins and correct the distortion that this produces, it is essential to combine this reason with another and thus obtain a more realistic position of the company. This is helped by the DUPONT analysis.
This ratio relates the management indexes and profit margins, showing the interaction of this in the profitability of the asset.
The matrix of the DUPONT System exposed at the end, allows us to visualize in a single table, the main accounts of the balance sheet, as well as the main accounts of the income statement. Likewise, we observe the main financial reasons for liquidity, activity, debt and profitability.
In our example for 2004, we have:
We have, for each MU invested in the assets, a return of 9.67% and 9.87% respectively, on the capital invested.
4. Limitations of the ratios
Despite the advantage that ratios provide us, they have a series of limitations, such as:
- Difficulties in comparing several companies, due to the differences in the accounting methods of valuation of inventories, accounts receivable and fixed assets. They compare the profit under evaluation with a sum that contains the same profit. For example, when calculating the return on equity, we divide the profit for the year by the equity at the end of the same year, which already contains the profit obtained that period as profit to be distributed. Given this, it is preferable to calculate these indicators with the equity or assets of the previous year. They are always referred to the past and are merely indicative of what may happen. They are easy to handle to present a better situation of the company. They are static and they measure levels of bankruptcy of a company.
Bibliography
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