Question 1 Accounting ratios
Accounting ratios, or financial ratios, are comparisons made between one set of figures from a company’s financial statement with another. We use accounting ratios to determine whether a business can pay its debt and how profitable it is, was it worth to invest or was it occurred with high risk to invest. Additionally, accounting ratios are used to predict whether a company is likely to go bankrupt soon. Overall, the aim when studying these ratios is to help us analyze trends and company financial structures. Accounting ratios are indicators of a commercial entity’s performance and financial situation, it can be calculated from the data provided by the firms. Financial ratio sources could be the balance sheet, income statement, or statement of cash flows. The statement of changes in equity is also a source. The data comes from either within the company’s financial statements or its accounting statements. (MBN, 2018). These accounting ratios are important because it interprets the current financial statements in the operation performance and financial position of a firm. There are many different types of accounting ratios we could use depending on the information and data given by the firm. In view of the needs of various uses of the ratios, which can be calculated from the accounting data are classified into the four broad categories which is liquidity ratio, turnover ratio, leverage ratios, and profitability ratios.
In accounting, the term liquidity is defined as the ability of a company to meet its financial obligations as they come due. The liquidity ratio, then, is a computation that is used to measure a company’s ability to pay its short-term debts, that is capacity of the firm to pay its current liabilities as and when they fall due. (Hill, n.d.). Thus, these ratios reflect the short-term financial solvency of a firm. A firm should ensure that it does not suffer from lack of liquidity. The failure to meet obligations on due time may result in bad credit image, loss of creditors confidence, and even in legal proceedings against the firm in the other hand. A very high value of liquidity is also not desirable since it would imply that funds are idle and earn nothing. Therefore, it is necessary to strike a proper balance between liquidity and lack of liquidity. (Munjal, 2018). There are three common calculations that fall under the category of liquidity ratios which is the current ratio, acid test ratio or quick ratio, and absolute liquid ratio or cash ratio. The current ratio stated that a company’s ability to pay under short-term solvency. It establishes the relationship between current assets and current liabilities. The formula is Current ratio=(Current asset)/(Current liabilities). The acid test ratio measures the ability of a company to pay its current liabilities when they come due with only quick assets which are the current assets that can be converted to cash in short-term such as sundry debtors, short-term marketable securities and else. The formula is Acid Test ratio=(Quick Assets)/(Current Liabilities) . The absolute liquid ratio establishes the relationship between super quick current assets and liabilities, the formula is Absolute liquid ratio=(Absolute liquid assets)/(Current liabilities) .
The turnover ratio can be defined as the ratio to calculate the quantity of any asset which is used by a business to generate revenue through its sales. It is the relation between the amount of company’s asset and the revenue generated from them. To be more precise, it is an efficiency ratio to check how efficiently the company is using different assets to extract earnings from them. A higher ratio is considered better as it would indicate that the company is optimally using the resources to earn revenue and it would imply a higher return on investment. (Borad, 2018). In other words, a high turnover ratio is a sign that the company is producing and selling its goods or services very quickly. However, a low turnover ratio implies weak sales or excess inventory, which mean the company may not have enough profit earned from sales and would lead to economic break down if the sales is still low. Normally, the calculations of turnover ratios can be divided into inventory turnover ratio, debtor turnover ratio, creditor turnover ratio, and assets turnover ratio. (Munjal, 2018). The inventory turnover ratio shows the number of times the inventory has been converted into sales during the period, the formula is Inventory Turnover ratio=(Cost of goods sold)/(Average Inventory) . The debtor turnover ratio shows that how many times a company collecting debts from its trade debtors during a year, the formula is Debtor Turnover ratio=(Net Credit Sales)/(Average Trade Debtors) . The creditor turnover ratio shows the number of times sundry creditors have been paid by the company during a year, the formula is Creditor turnover ratio=(Net Credit Purchases)/(Average Trade Creditor) . The assets turnover ratio shows how efficiently a company using it assets to generate revenue, it can be review as the performance of how many revenues can be generated per dollar of assets.
A leverage ratio is any one of several financial measurements that look at how much capital comes in the form of debt or assesses the ability of a company to meet its financial obligations. (Leverage Ratio, n.d.). This ratio also measure the ability of the business to meet its long-term debt obligations which is the ability to repay the principal amount when due and the regular payment of the interest, such as interest payments on debt, and any other fixed obligations like lease payments. (Peavler, 2018). Leverage ratios are essentially measures of risk, since a borrower that cannot pay back its debt obligations is at considerable risk of entering bankruptcy protection. However, a modest amount of leverage can be beneficial to shareholders, since it means that a business is minimizing its use of equity to fund operations, which increases the return on equity for existing shareholders. (Bragg, Leverage ratios, 2018). The ratio is based on the relationship between borrowed funds and owner’s capital it is computed from the balance sheet, the second type are calculated from the profit and loss accounts. The various solvency ratios are Debt equity ratio, debt to total capital ratio, proprietary ratio, fixed assets to net worth ratio, fixed assets to long term funds ratio, and interest coverage ratio. (Munjal, 2018). The debt equity ratio shows how much debt a company is using to finance its assets relative to the value of shareholders’ equity, which is used to measure a company’s financial leverage. (Debt/Equity Ratio, n.d.). It is calculated by Debt Equity Ratio=(Total Debts)/(Shareholders^’ Equity) . The debt to total capital ratio provided how much capital employed is transformed into debt by the company, it indicates the financial structure and health of company, it is calculated by Debt to total capital ratio=(Total Debts)/(Total Assets) . The proprietary ratio shows whether a company has enough equity to support the operation of business, it is calculated by Proprietary ratio=(Shareholder funds)/(Total assets) . The fixed assets to net worth ratio indicates a company’s solvency whether it rely too much fixed assets to meet its current debt obligations, it is calculated by Fixed assets to net worth ratio=(Fixed Assets)/(Net worth) . Fixed assets to long term fuds ratio establishes the relationship between fixed assets and long-term funds and is calculated by Fixed assets to long term funds ratio=(Fixed Assets)/(Long-term Funds) . The debt service coverage ratio shows the number of times the earnings of the firms can cover the fixed interest liability of the firm. It is calculated by Debt Service ratio=(Earnings before interest and tax (EBIT))/(Interest Charges) .
Every firm is most concerned with its profitability. One of the most frequently used tools of financial ratio analysis by the investor and shareholders is profitability ratio, which are used to determine the company’s bottom line and its profits return to its investors. Profitability measures are important to company managers and owners alike because it interpret how much profits have been earned from the company. (Peavler, Profitability Ratio Analysis, 2018). Mostly, investors like to invest on company with high profitability ratios because when a company has profit, they can pay more dividend to their shareholders, which are the investors. Basically, profitability ratio compares income statement accounts and categories to show a company’s ability to generate profits from its operations. Profitability ratios focus on a company’s return on investment in inventory and other assets. These ratios basically show how well companies can achieve profits from their operations. Investors and creditors can use profitability ratios to judge a company’s return on investment based on its relative level of resources and assets. In other words, profitability ratios can be used to judge whether companies are making enough operational profit from their assets. In this sense, profitability ratios relate to efficiency ratios because they show how well companies are using their assets to generate profits. (Profitability Ratios, n.d.). Profitability ratios are derived from a comparison of revenues to difference groupings of expenses within the income statement. For examples, there are gross profit margin, net profit margin, operating profit margin, operating ratio, and expenses ratio. (Munjal, 2018). Gross profit ratio measures the relationship between gross profit and sales, the formula is GPM=(Gross profit)/(Net sales) . Net profit ratio illustrates how much of each dollar collected by company as revenue transformed into profit, the formula is NPM=(Net Profit)/(Net Sales) . The operating ratio shows the efficiency of a company to control the costs and expense, whether they have spent too much revenue on expenses. The calculation is Operating ratio=(Operating expenses)/(net sales) . Operating profit ratio indicates how much profit a company made after paying several costs such as wages and raw materials. (Wilkinson, 2013). It is calculated by Operating profit=(Operating profit)/(Net sales) .
(a) The data of financial performance released by Key company has an important role in overview the company’s performance by comparing the data within each period in order to look for a better solution in improving the company. It is also important for the investors because these financial performances can be used to analyze whether the company is operating healthily, have a strong financial position and is suitable to invest in the company.
PE ratio=(market value per share)/(Earnings per share (EPS))
The price to earnings ratio (PE) is calculated by dividing market value per share with earnings per share (EPS), it indicates the dollar amount an investor can expect to invest in a company in order to receive one dollar of the company’s earnings. It can also be referred as the price multiple because it shows how much money an investor willing to pay for getting one dollar of shares earnings. (Price-Earnings Ratio – P/E Ratio, n.d.). In other words, PE ratio shows the current investor’s demand for getting a company share. When a high PE ratio is occurred, or the PE ratio is increasing, it illustrates that the investors have high demand in getting a share of the company because they anticipate that there might be an earnings growth of the company in the future. Therefore, the PE ratio can be used by investors to analyse the financial performance of the company as if the company performing badly, the earnings per share drop and the PE ratio drop too. Keys company has an increasing PE ratio starting from year 2012, which is 24.9 to year 2015, which is 39.93, this illustrates that the company is performing well and earned profit, therefore investors are willing to pay for higher price per share. But during year 2016, the PE ratio drop to 27.46, which indicates that the investors have low demand in the shares maybe due to the company has some financial problems and their earnings per share drop.
Dividend is one of the most important tools investors looking and using for analysing the financial structure of the company and the profit earned by investors themselves. Basically, dividend is the amount of money returning by the company to shareholders when it has earned income. Normally, the dividend of a company is low or even with zero dividend because a new and growing company will aim to expand it business and products, therefore it would reinvest most or all its earnings and income into the business or payoff it’s debts to stabilize their financial positions. If a company has an increasing dividend or high dividend, it means that the company has growth mature enough with high cash flow that it can has extra earnings for returning to shareholders, investors willing to invest in this kind of company because it has more stable financial positions. From the datasets provided by Key company, it showed that they have an increasing amount of pay out dividends every year starting from year 2012 with 1.56 to year 2016 with 2.40. This illustrates that Key company is having a good and stable financial performance in the market and have enough cash flow to handle their debts and other expenses.
ROA=(Net Income)/(Total Assets)
Return on assets (ROA) is commonly used by manager of company, investor, shareholders, or analyst to calculated how efficiently a company using its assets to generate earnings. Different kind of industry has its own average percentage of ROA; therefore, it is better to compare with the previous ROA values of the same company or compare with another similar company. The higher the ROA, the better the company’s performance because the company is earning more money with less money used in investment. The ROA is important for investors because they can analyse if the management of the company is well or bad in implementing a good financial policy or investment in order to overcome their debts and other expenses. (Staff, n.d.). The value of ROA of Key company has increased and decreased over the period, it has decreased a lot from 15.42% to 9.35% in year 2015 but soon regained to 13.25% during the next year.
ROE=(Net Income)/(Shareholders^’ Equity)
Return on equity ratio (ROE) is one of the concerns of investors, it measures the profitability of how much profit a company can generates with the money invested in it, in other words, it shows how many dollars of profit the company generates with every single dollar of shareholders’ equity used in investments. The value of ROE is difference between each type of industry, therefore it is better to compare with different company in the same industry. Besides measuring the profit, ROE can also refer to the efficiency of a company, a high ROE indicates how well the company’s management is deploying the capital, turning cash put into business for better gains. The performance of Key company has dropped from 70.1% to 41.82% at the end of year 2015, this mean that the company is having issues at making profit with the used of equity. But the value has raised up to 80.73% after a year, which indicates the company earned $0.8 profit with every $1 dollar invested.
Financial Leverage ratio=(Total Debt)/(Total equity)
Financial leverage ratio is one of several financial measurements that look at how much capital comes in the form of debt or assesses the ability of a company to meet its financial obligations because a company rely on a mixture of equity and debt to run their business. This is important because it show how much the company assets belong to the shareholders or debt, if a company is said to be highly leveraged, most of it assets is belong to debt rather than the equity and when there is more debt, the interest paid would also increase, this would lead to bankruptcy or unable to payoff its debts when they come due. These measurements are important for investors to analyses whether the company is having a good or bad capital structure that could afford its debt and is it risky or safe to invest in it. (Alim, n.d.). From the above indicators, Key company has a low rate of leverage with 3.34 in year 2013 but continue to increase per year to 7.03 in year 2016, this indicates that the company has increase in total debt.
D/E ratio=(Total Liabilities)/(Shareholders^’ Equity)
Debt/Equity ratio (D/E) is a ratio under the category of financial leverage ratio, it is also used to measure a company’s financial leverage. It shows the relationship between the capital contributed by creditors and the capital contributed by shareholders. If a D/E ratio is high, it indicates that the company has been aggressive in financing its growth with debt which may cause unpredictable results to the company. When a company financed a lot of debt, it could possibly generate more earnings from investment and else, but if the earnings returned less than the amount of the interest paid generated by the debt, the cost of debt will become too much for the company to handle, it may lead to bankruptcy or maybe zero dividend to the shareholders as the earnings are paid to the creditors first. Therefore, it is important for investors to look into this ratio to analyse whether the company is having too much amount of debt to themselves and can they afford to pay dividend to the shareholders. (Debt/Equity Ratio, n.d.). From the above table results shown, Key company has more debt compared to its equity, the rate is between one to two in the first four years but has been increased to 2.99 in year 2016. This indicates that the company has been using more debt in financing their growth.
Current Ratio=(Current Asset)/(Current Liabilites)
The current ratio is most frequently used in the accounting ratios, whether by the company itself or the investors. The current ratio indicates a company’s ability to pay under short-term solvency, which mean the ability to pay the debt that has come due with the assets. The main idea of current ratio is of a company’s ability to pay back its debt, but it can be roughly estimate as the company’s financial health because it shows the relationship between current asset and current liabilities. If the ratio is below one, it indicates that the company’s liabilities are higher that its assets, and the company should find a solution in it when its obligations came due because it has insufficient assets to pay off the debt. However, a high ratio does not mean that the company is in good financial health. When the ratio is high, it indicates that the company has not used its assets efficiently in financing, there are surplus assets that could be used in investment to generate more revenue to the company. (Current Ratio, n.d.). It might not be the best indicator for investors, but it can still roughly estimate the condition of a company, which can still be used in analyse. The current ratio rate given from the Key company has been continuing decrease started from 1.77 in year 2013 to 0.83 after two years and slightly increased to 0.95 in the following year, the ratio has dropped below one, which indicates that the company has less assets compare to the liabilities, the company should examine their financial operation to increase its assets and decrease its debt.
Quick Ratio=(Quick Asset)/(Current Liabilities)
Unlike current ratio, quick ratio is more focus on the asset that are liquidity, which are cash, market securities, and accounts receivable, inventory is not included because it may be hard to sell off in short period and a loss might be occurred during the selling process. This ratio can show more efficient of a company’s ability in paying obligations because in most industry, the inventory comprises a large part of the current assets which will be hard to convert into cash within short period. (Bragg, Quick ratio | Acid ratio | Liquidity ratio, 2017). A quick ratio below one might mean that the company has heavily relying on its inventory or other assets to pays in its obligations; while a high ratio indicate that the company has too much cash in reserve, they could use it in investment or else. It can also mean that the company is having a high accounts receivables amount, which indicates that the company might having problems collecting its account receivables. (Quick Ratio, n.d.). Overall quick ratio is still a better indicator than the current ratio and for the use of investors. The quick ratio of Key company has been decreasing from 0.81 in the first year to 0.43 in the forth year and slightly increase in the following year. This indicates that the company has less quick asset compared to the liabilities, the company might be having problems when facing the obligations.
Asset Turnover ratio=(Total Sales)/(Total Asset)
Asset turnover ratio is usually used by third parties to roughly evaluate the operations of a company business, with high ratio it means the company is performing well in making more revenue. A company with high ratio indicates that it can operate with fewer assets, equity, and also with less debt, it can generate more sales with lesser assets used. In this case, a high asset turnover ratio indicates that the shareholders may get a better return from the company. Additionally, it is better to plot the ratio into a trend line to spot the significant changes over time because in the same industry, there might be a different disparity between each other as some company tend to have more asset on its own. The asset turnover ratio is often used as an indicator by investors, it allows them to have an idea on how efficiently a company produced sales. (Bragg, Total asset turnover ratio, 2017). From the above table shown, the asset turnover ratio of Key company does not have much changes over the five years, it is around 1.3 to 1.4.
Cash Conversion Cycle=DSO+DIO-DPO
The cash conversion cycle (CCC) is an efficient ratio which measures the number of days a company’s cash is tied up with it inventories, accounts receivable, and the payment make to creditors. The formula is measured in unit days and using the days sales outstanding (DSO) which is the days to collect accounts receivables from debtors, days inventories outstanding (DIO) which is the number of days it takes to sell inventories, and days payable outstanding (DPO) which is the days to pay off the raw materials outstanding to calculate it. The CCC is important because it show the efficiency of how a company managing it working capital and a clear view of the ability to payoff its liabilities. The shorter the period of it, the greater the liquidity of the company. Short period indicates that the company is selling its inventories faster and receiving cash back from the credits sales quickly, while it also means that the company is paying off its debt as slow as possible at the same time, all of these show the liquidity of a company. As an investor, it is well-advised to look into this ratio because aside from quick ratio, this ratio is more significant in showing the true liquidity of a company. (Liquidity Measurement Ratios: Cash Conversion Cycle, n.d.), (Cash Conversion Cycle, n.d.). From the Key company, it shows that the company has an increased in the ratio, the number of days are increasing over time, this indicates that the company might facing problems in selling inventory, have a long period in collecting cash form accounts receivable, or maybe paying off its debt more often.
(b) It is important to know that the financial statements or financial ratios help the investors and analyst from analysing the company operation and help us to understand the current status of the company, whether they are performing well, or could they have a strong potential to stand over other companies in the industry for the following few years. Most of the people would just look into the financial statements and perform the calculation of ratios to evaluate the company, but besides from looking on these statements, there are still some non-financial statements items and details we could look from the company. As we know, the value of ratios to identify the company’s operation status is different between each type of industry, this is because every industry has their own operation characteristics, and we cannot compare these companies which are less related to avoid the accurate of analysis. Therefore, in order to be more accurate in doing analysis statements, it is recommended that we could also look into the status of a company or non-financial statements for better understanding and measurements.
The first thing that we could look into from the company is their organization structures. An organization structure of a company can normally be used to determine whether the company required the abilities to survive from the competition among the industry, a good organization can manage to increase their financial performance with great communication and teamwork, while they are unflappable when facing high pressure conditions such as financial crisis because they have unified marketing message among each department, knowing their own position in the operating of company, when the whole organization have better understanding against their goals, it helps to increase their working performance and strengthen the company. A company should have an organized system that indicate how the activities and operation are operated inside the company, these activities include rules of operations, roles of every worker’s duties, and the responsibilities of each department in order to fulfil the objectives of a project and achieve the goals of the company. Besides, a prominent company has always equipped with good and accurate messages flows between each department, a wrong transmitted information may lead to wrong decision making and delay the progress of the operation. Moreover, when a company has a strong organization structure, they can easily manage their resources because they have better understanding over each department, knowing their operation progressing. Since resources are limited and expensive, an efficient organization always try to reduce their cost by eliminating unnecessary wastage of resources, so they will allocate the resources efficiently to each department to fully utilize the resources. When the company have good management, it could be seemed as they can also control over their liabilities and the used of assets, the company can manage to invest more money and earn more revenue by fully utilizing their resources. (Brown, n.d.), (III, 2018), (Organizational Structure, n.d.). Even if the company does not have an impressive financial ratio value, the company is still worth to consider investing because it is safer when it has a good organization structure, the company is able to survive in the economy and will have a chance to increase in performance and manage to fully utilize their resources to increase revenue. Therefore, investors can also refer to the background and status of the company’s organization to estimate the financial operation of it.
Furthermore, corporate transparency of the company has been a famous subject over the year, investors as well as customers have been concerned about the reliability and credibility of the company. As we know, the market is a place full of cruel and competition, most of the company will try many methods to survive and distinguish themselves, attracting investors is also a way to improve the company itself, but when investors are facing several companies with similar financial status, it is hard to choose whether which company is better to invest. Transparency in business requires them to remain open and providing information about their operation, business’s goal, and performance. (Alton, 2017). Transparency is important because it can provide certainty for investors, when the financial statements are not transparent, investors will feel that the company is trying to hide some information and they cannot know about the company’s real financial situation and the true risk of investment, lack of transparency can be review as obscure the company’s debt level. Investors are easily to be fraudulent by the company when they release misleading information, commercial fraud cases have been occurred in the market, which making investors have less confident to a company without enough transparency. Investors should seek for disclosure and simplicity from the company, the more transparency a company is, the more investors it will attract, transparency does not just help investors to clearly overview the financial status of the company, it also helps the company in attracting more investors, providing more equity and indirectly create more profit. (McClure, n.d.), (Exchange, 2012).?