To evaluate the financial condition and performance of a organization, managers need use finance ratios analysis. Financial ratios state particular relationship from balance sheets and income statement. Ratio analysis does not merely involve the application of a formula to financial data, but more important is the interpretation of the ratio value.
Financial ratios can be used to show:
- The firm's position in its industry.
- The degree to which strategic objectives are being accomplished.
- The firm's vulnerability to decreases in revenue.
- The future borrowing power and growth potential of the firm.
- The firm's ability to react to unforseen changes in the environment.
- The risk of corporate failure.
Key financial ratios are defined in Table 5-7.
Use Of Financial Ratios
To evaluate the performance of a company with respect to financial ratios, the following three methods are used: cross-sectional, time-series and combined analysis.
Cross-sectional analysis involves the comparison of different firm's financial ratios at the same point in time. Through using published financial data, the strategist can analyze the behaviour and competence of rival firms within the industry and make judgements about his own firm's relative competitive position. There are several widely used sources of industry average ratios.
Average ratios for Canadian industries are published annually by sources such as Leibovitz and Statistics Canada. Leibovitz coordinates the publication of 32 key ratios for different industries annually; the financial data of this publication is supplied by Statistics Canada. In the United States, Dun and Bradstreet publishes on an annual basis a set of 14 key ratios for each of the 15 lines of business. Robert Morris Associates also publishes on a n annual basis a set of 16 key ratios for ever 350 lines of business.
A sample from one available source of industry averages is given in Table 5-6.
However, any deviations from the norm merely directs the analyst to potential areas of concern: it does not provide conclusive evidence as to the existence of a problem.
Time-series analysis is applied when a financial analyst evaluates performance over time. This function has the responsibility of ensuring that the strategic plans and objectives of the firm are feasible for the financial resources which it has. The most informative approach to ratio analysis is one that combines cross-sectional and time-series analysis.
Combined analysis combines cross-sectional and timesseries analyses. Figure 5-1 illustrates combined crosssectional and time-series of Bartlett Oil Company's average collection period, 1985-1988.
Comparisons firms with the industry must be approached with caution when comparing financial ratios of one company with those of other companies in the industry. We need more information on the dispersion of the distribution of ratios in order to judge the significance of the deviation of a financial ratio for a particular company from the industry norm. It may be that companies with multiply product lines often defy precise industry categorization.
Also, companies in an industry may differ substantially in size. Sometimes the financial condition and performance of the entire industry is less than satisfactory, and a company's being above average my not be sufficient. On the other hand, the firm may have a number of problems on a absolute basis and not should take refuge in a favorable comparison with the industry.