3.0. Core application of data analytics

3.1. Financial Accounting And Reporting

3.1.2. Analyse financial statements using ratios, common size statements, trend and cross-sectional analysis, graphs and charts

Analyse financial statements using ratios

Analyzing financial statements using ratios is a fundamental component of data analytics in finance. This process involves assessing a company's performance and financial health by comparing various financial metrics derived from its statements. By calculating ratios such as profitability (e.g., return on assets or net profit margin), liquidity (e.g., current ratio or quick ratio), and solvency (e.g., debt-to-equity ratio), analysts gain valuable insights into a company's operational efficiency, its ability to meet short-term obligations, and its long-term financial stability. These ratios serve as crucial benchmarks for decision-makers, helping them make informed choices related to investments, lending, and strategic planning. In today's data-driven business landscape, the use of data analytics in dissecting financial statements through ratios is indispensable for making well-informed financial decisions and mitigating risks.

Financial Ratios

Financial ratios serve as essential tools for investors, analysts, and businesses to evaluate a company's financial performance and overall stability. These ratios are derived from various financial data found in a company's financial statements, such as the income statement, balance sheet, and cash flow statement. They offer valuable insights into aspects like profitability, liquidity, solvency, and efficiency. Some widely used financial ratios include the price-to-earnings ratio (P/E), debt-to-equity ratio, return on investment (ROI), and current ratio. Through the examination of these ratios, stakeholders can make well-informed decisions regarding investments, lending, or the overall financial health of a company.

1. RATIO ANALYSIS
   • Ratios are mathematical relationships between different financial elements and are used to evaluate various aspects of a company's performance.
   • Common financial ratios include liquidity ratios (e.g., current ratio, quick ratio), profitability ratios (e.g., gross margin, net profit margin), leverage ratios (e.g., debt-to-equity ratio), and efficiency ratios (e.g., inventory turnover, accounts receivable turnover).
   • Ratios provide a snapshot of a company's financial condition and can be used for benchmarking against industry standards or competitors.
   
   
   Financial Ratio Analysis:
   
   Financial ratios help assess the organization's financial performance and health. Some important financial ratio include:
   
   

   1. Liquidity Ratios (e.g., Current Ratio, Quick Ratio):

      
      
      Measure the entity's ability to meet short-term obligations.
      Liquidity ratios are a set of financial ratios that assess a company's ability to meet its short-term financial obligations. They measure the organization's liquidity or its ability to convert assets into cash to pay off its short-term debts. These ratios are crucial for creditors, investors, and management to gauge the company's short-term financial health and its ability to handle unexpected financial challenges. Some common liquidity ratios include:
      
      ➧ Current Ratio: It is calculated by dividing the company's current assets by its current liabilities.
      
      Current Ratio = Current Assets / Current Liabilities
      
      The current ratio indicates whether the company has enough current assets to cover its current liabilities. A ratio above 1 indicates that the company can pay off its short-term obligations, while a ratio below 1 suggests potential liquidity issues.
      
      ➧ Quick Ratio (Acid-Test Ratio): This ratio is more stringent than the current ratio, as it excludes inventories (which may not be easily converted to cash) from current assets.
      
      Quick Ratio = (Current Assets - Inventory) / Current Liabilities
      
      The quick ratio provides insight into a company's ability to meet its short-term obligations using only its most liquid assets.
      
      ➧ Cash Ratio: The cash ratio is the most conservative liquidity ratio as it considers only the most liquid asset - cash and cash equivalents - in relation to current liabilities.
      
      Cash Ratio = Cash and Cash Equivalents / Current Liabilities
      
      

      This ratio gives a clear picture of whether a company can immediately cover its current liabilities using only its cash reserves.

      
      

      Liquidity ratios help stakeholders assess a company's short-term financial health and its ability to manage day-to-day operations, pay its debts, and navigate economic downturns or unforeseen events. Different industries may have different acceptable ranges for these ratios, so it's important to consider industry benchmarks and historical trends while analyzing liquidity ratios. Additionally, using multiple liquidity ratios together provides a more comprehensive understanding of a company's liquidity position.

   
   

   2. Solvency Ratios (e.g., Debt-to-Equity Ratio):

      
      
      Indicate the organization's long-term financial stability.
      Solvency ratios are a group of financial ratios that measure a company's ability to meet its long-term debt obligations and demonstrate its financial stability over the long term. These ratios assess the company's capital structure and whether it has enough assets to cover its long-term liabilities. Solvency ratios are vital for creditors, investors, and management as they indicate the company's long-term financial health and its ability to endure economic challenges. Some common solvency ratios include:
      
      ➧ Debt-to-Equity Ratio (D/E): This ratio compares a company's total debt to its shareholders' equity.
      
      Debt-to-Equity Ratio = Total Debt / Shareholders' Equity
      
      A high debt-to-equity ratio may suggest that the company relies heavily on debt financing, which could increase financial risk. On the other hand, a lower ratio indicates that the company is more reliant on equity financing, which might signify a stronger financial position.
      
      ➧ Debt Ratio: The debt ratio assesses the proportion of a company's assets that are financed by debt.
      
      Debt Ratio = Total Debt / Total Assets
      
      The debt ratio provides insights into the company's overall leverage and its ability to withstand economic downturns.
      
      ➧ Interest Coverage Ratio (ICR): This ratio evaluates the company's ability to meet interest expenses on its debt.
      
      Interest Coverage Ratio = Earnings Before Interest and Taxes (EBIT) / Interest Expenses
      
      A higher interest coverage ratio indicates that the company has sufficient earnings to cover its interest payments, which is a positive sign of solvency.
      
      ➧ Debt-Service Coverage Ratio (DSCR): The DSCR assesses a company's capacity to meet its debt obligations, including both principal and interest payments.
      
      Debt-Service Coverage Ratio = Net Operating Income(EBIT) / Total Debt Service(Principal + Interest)
      
      

      A DSCR greater than 1 suggests that the company generates enough income to cover its debt service obligations, while a DSCR less than 1 may indicate potential difficulties in servicing debt.

      
      

      Solvency ratios provide valuable insights into a company's long-term financial health, its ability to manage long-term debt, and its capacity to weather financial challenges. As with liquidity ratios, solvency ratios' interpretation may vary depending on the industry and specific circumstances, so it's crucial to consider industry benchmarks and historical trends when analyzing solvency ratios. A combination of different solvency ratios can offer a comprehensive view of the company's financial stability and its capability to meet long-term obligations.

      
      
   
   

   3. Efficiency Ratios (e.g., Asset Turnover, Receivables Turnover):

      
      Evaluate how effectively the entity utilizes its assets and manages its receivables.

      Efficiency ratios, also known as activity ratios, are financial metrics that evaluate a company's operational efficiency and how effectively it utilizes its assets to generate sales and profits. These ratios help assess a company's ability to manage its resources, control costs, and optimize its operations. They are essential for understanding a company's productivity and operational effectiveness. Some common efficiency ratios include:

      
      ➧ Inventory Turnover Ratio: This ratio measures how efficiently a company manages its inventory by dividing the cost of goods sold (COGS) by the average inventory during a specific period.
      
      Inventory Turnover Ratio = Cost of Goods Sold (COGS) / Average Inventory
      
      A high inventory turnover ratio indicates that a company is selling its inventory quickly, which is generally favorable as it reduces holding costs and frees up working capital.
      
      ➧ Accounts Receivable Turnover Ratio: This ratio assesses how efficiently a company collects its accounts receivable by dividing net credit sales by the average accounts receivable during a particular period.
      
      Accounts Receivable Turnover Ratio = Net Credit Sales / Average Accounts Receivable
      
      A higher accounts receivable turnover ratio suggests that a company is collecting payments from customers more quickly, indicating effective credit management.
      
      ➧ Accounts Payable Turnover Ratio: This ratio evaluates how efficiently a company manages its accounts payable by dividing the total purchases by the average accounts payable during a specific period.
      
      Accounts Payable Turnover Ratio = Total Purchases / Average Accounts Payable
      
      A higher accounts payable turnover ratio indicates that the company is paying its suppliers quickly, which can improve its relationship with suppliers and may lead to favorable terms.
      
      ➧ Asset Turnover Ratio: This ratio measures how efficiently a company uses its total assets to generate revenue by dividing total revenue by average total assets.
      
      Asset Turnover Ratio = Total Revenue / Average Total Assets
      
      A higher asset turnover ratio suggests that the company is generating more revenue per dollar of assets, indicating effective asset utilization.
      
      ➧ Operating Cycle Ratio: This ratio evaluates the efficiency of a company's operating cycle, which is the time it takes to convert inventory into cash. It is the sum of the average age of inventory and the average collection period for accounts receivable.
      
      Operating Cycle Ratio = Average Age of Inventory + Average Collection Period
      
      A shorter operating cycle indicates that the company is converting its inventory into cash quickly, leading to improved liquidity.
      
      Efficiency ratios help identify areas where a company can improve its operations and resource management. By comparing these ratios with industry benchmarks and historical trends, stakeholders can gain valuable insights into the company's performance and competitive position in the market.
   
   

   4. Profitability Ratios (e.g., Return on Assets, Return on Equity):

      
      Assess the entity's ability to generate profits relative to its resources.

      Profitability ratios are financial metrics that assess a company's ability to generate profits in relation to its sales, assets, equity, and other factors. These ratios provide insights into a company's overall financial performance and its efficiency in converting sales and assets into profits. Profitability ratios are essential for investors, creditors, and management to evaluate the company's profitability and financial health. Some common profitability ratios include:

      
      ➧ Gross Profit Margin: This ratio measures the percentage of revenue that exceeds the cost of goods sold (COGS). It indicates how efficiently a company produces its goods or services.
      
      Gross Profit Margin = (Gross Profit / Revenue) x 100
      
      A higher gross profit margin suggests that the company is efficiently managing its production costs and is generating a larger portion of revenue as profit.
      
      ➧ Operating Profit Margin: Also known as Operating Margin or Return on Sales (ROS), this ratio measures the percentage of revenue that remains after deducting both COGS and operating expenses.
      
      Operating Profit Margin = (Operating Profit / Revenue) x 100
      
      A higher operating profit margin indicates that the company is running its operations efficiently and has better control over its operating expenses.
      
      ➧ Net Profit Margin: This ratio represents the percentage of revenue that remains as profit after all expenses, including taxes and interest, have been deducted.
      
      Net Profit Margin = (Net Profit / Revenue) x 100
      
      A higher net profit margin signifies that the company is generating more profit for each dollar of revenue and is managing its costs effectively.
      
      ➧ Return on Assets (ROA): This ratio measures the company's ability to generate profits from its total assets.
      
      Return on Assets (ROA) = (Net Income / Average Total Assets) x 100
      
      ROA indicates how efficiently the company is utilizing its assets to generate profits.
      
      ➧ Return on Equity (ROE): This ratio assesses the company's ability to generate profits for its shareholders in relation to their equity investment.
      
      Return on Equity (ROE) = (Net Income / Average Shareholders' Equity) x 100
      
      ROE shows how effectively the company is using shareholders' equity to generate earnings.
      
      

      Profitability ratios provide valuable insights into a company's financial performance and its ability to generate returns for investors. Comparing these ratios over time and against industry benchmarks can help stakeholders identify trends, strengths, and weaknesses within the company's operations and financial strategy.

      
      

      Importance of Financial Ratios

      
      

      Financial ratios are important tools for analyzing the financial health, performance, and stability of a company. They provide valuable insights into various aspects of a company's operations and can be used by investors, creditors, management, and other stakeholders for decision-making and assessment. Here are some key reasons why financial ratios are important:

      
      

      1. Performance Evaluation: Financial ratios allow stakeholders to assess a company's performance over time. By comparing ratios across different periods, you can track improvements or declines in financial performance, which helps in making informed investment or management decisions.
      2. Comparative Analysis: Financial ratios enable you to compare a company's performance to that of its competitors or industry benchmarks. This helps investors and management identify strengths and weaknesses relative to peers, facilitating better strategic planning and goal setting.
      3. Risk Assessment: Ratios can highlight a company's financial risks. For example, high levels of debt relative to equity (high debt-to-equity ratio) can indicate a higher risk of financial distress, while a low current ratio may signal liquidity risk. This information helps creditors and investors assess the risk associated with a company.
      4. Liquidity Analysis: Ratios like the current ratio and quick ratio assess a company's ability to meet short-term obligations. These ratios are crucial for determining whether a company can cover its immediate financial obligations without relying on external sources of financing.
      5. Profitability Analysis: Profitability ratios, such as the net profit margin and return on equity (ROE), help assess a company's ability to generate profits and returns for shareholders. They are essential for investors looking for companies with strong profitability potential.
      6. Efficiency Measurement: Ratios like inventory turnover and accounts receivable turnover measure how efficiently a company manages its assets. High turnover ratios indicate effective asset utilization, which can lead to cost savings and increased profitability.
      7. Investor Decision-Making: Investors use financial ratios to evaluate potential investments. Ratios provide a quantitative basis for comparing different investment options and determining whether a company's financials align with an investor's goals and risk tolerance.
      8. Creditworthiness Assessment: Creditors and lenders use financial ratios to evaluate a borrower's creditworthiness. By assessing a company's financial ratios, creditors can determine the likelihood of repayment and set lending terms, including interest rates and loan amounts.
      9. Management Tools: Companies use financial ratios as management tools to monitor performance, set financial targets, and identify areas for improvement. Ratios can help management make informed decisions about resource allocation and strategy.
      10. Early Warning Signs: Certain ratios can serve as early warning signs of financial distress. For example, a declining gross profit margin or increasing leverage ratios may indicate potential problems that require prompt attention.

      
      Financial ratios are critical for assessing a company's financial health, making investment decisions, managing risk, and guiding strategic planning. They provide a standardized way to analyze financial data and are essential for stakeholders seeking to make informed financial judgments and choices.