Ratio and Financial Statement Analysis Essay

Download this Essay in word format (.doc)

Note: Sample below may appear distorted but all corresponding word document files contain proper formatting

Excerpt from Essay:

The data must be absolutely correct.

3. Effects of Price Level Changes: Price levels changes often make the comparison of figures difficult over a period of time. Changes in price affect the cost of production, sales and also the value of the assets. Therefore, it is necessary to make proper adjustment for price-level changes before any comparison.

4. Quality factors are ignored: Ratio analysis is a technique of quantitative analysis and thus, ignores qualitative factors, which may be important in decision-making. For example, an average collection period may be equal to standard credit period, but some debtors may be in the list of doubtful debts, which is not disclosed by ratio analysis.

5. Effect of window dressing: In order to cover up their bad financial position some companies resort to window dressing. They may record the accounting data according to the convenience to show the financial position of the company in a better way.

6. Costly Techniques: Ratio analysis is a costly technique and can be used by big business houses. Small business units are not able to afford it.

7. Misleading Results: In the absence of absolute data, the result may be misleading. For example, the gross profit of two firms is 25% whereas, the profit earned by one is just U.S.$5,000 and sales are U.S.$20,000 and profit earned by the other one is U.S.$10,000 and sales are U.S.$40,000. Even the profitability of the two firms is same but the magnitude of their business is quite different.

8. Absence of Standard University accepted terminology: There are no standard ratios, which are universally accepted for comparison purposes. As such, the significance of ratio analysis technique is reduced.

Financial Ratio Analysis and Formulas

Universal Teachers Publications (2010) outlines and explains the meaning, objective and method of calculation of the financial ratios as follows:-

(a.) Gross Profit Ratio:

This ratio shows the relationship between Gross Profit of the concern and its Net Sales; and it can be calculated as follows:-

Gross Profit Ratio = Gross Profit/Net Sales*100 whereby; Gross Profit = Net Sales

Cost of Goods Sold; and the Net Sale = Total Sales -- Sales Return.

Cost of Goods Sold = Opening stock + Net purchases + Direct Expenses -- Closing


According to Universal Teachers Publications (2010), the Gross Profit Ratio provides guidelines to the concern whether it is earning sufficient profit to cover administration and marketing expenses; and is able to cover its fixed expenses. Universal Teachers Publications claims that the gross profit ratio of current year is compared to the previous year's ratios of the other concerns; hence, the minor change in the ratio knows about any departure from the standard mark-up and would indicate losses on account of theft, damage, bad stock system, bad sales policies and other reasons. However, Universal Teachers Publications advises that it is desirable that this ratio must be high and steady because any fall in it would put the management in difficulty in the realization of fixed expenses of the business.

(b.) Net Profit Ratio:

According to Universal Teachers Publications (2010), the Net Profit Ratio shows the relationship between Net Profit of the concern and its Net Sales. Universal Teachers Publications decrees that Net Profit Ratio can be calculated in the following manner:-

Net Profit Ratio = Net Profit / Net Sales *100 whereby

Net Profit -- Selling and Distribution Expenses -- Office and Administration Expenses

- Financial Expenses -- Non-Operating Expenses + Non-Operating Income; and Net Sales = Total Sales -- Sales Return

In order to workout overall efficiency of the concern, Universal Teachers Publications (2010) claims that Net Profit Ratio is calculated. This ratio is helpful to determine the operational ability of the concern. When comparing the ratio to the previous years' ratios, the increment shows the efficiency of the concern.

(c.) Operating Profit Ratio

Operating profit means earned profit by the concern from its business operation and not from the other sources. While calculating the net profit of the concern all incomes either they are not part of the business operation like Rent from tenants, interest in Investment etc. are added and all non-operating expenses are deducted. Therefore, while calculating operating profits these all are ignored and the concern comes to know about its business income from its business operations. Meaning, Operating Profit Ratio shows the relationship between Operating Profit and Net Sales; and it can be calculated as follows:

Operating Profit Ration = Operating Profit/Net Sales*100 whereby

Operating Profit = Gross Profit + Non-Operating Expenses -- Non-Operating Incomes

Net Sales = Total Sales -- Sales Returns

Therefore, Operating Profit Ratio indicates the earning capacity of the concern on the basis of its business operations and not from earnings from the order sources; hence it shows whether the businesses is able to stand in the market or not.

(d.) Operating Ratio

Operating Ratio matches the operating cost to the net sales of the business. Operating Cost means cost of goods sold plus Operating Expenses.

Operating Cost = Operating Cost / Net Sales*100 whereby

Operating Cost = Cost of Goods Sold + Operating Expenses

Cost of Goods Sold = Opening Stock + Net Purchases + Direct Expenses -- Closing


Operating Expenses = Selling and Distribution Expenses, Office and Administration

Expenses, Repair and Maintenance

Operating Ratio is calculated in order to calculate the operating efficiency of the concern. As this ratio indicates about the percentage of operating cost to the net sales, so it is better for a concern to have this ratio in less percentage. The less percent of operating cost to the net sales, so it is better for a concern to have this ratio in less percentage; therefore, less percentage of cost means higher margins to earn profit.

(e.) Return on Investment or Return on Capital Employed

This ration shows the relationship between the profits earned before interest and tax and the capital employed to earn such profit.

Return on Capital Employed = Net Profit before Interest, Tax, and Dividend / Capital Employed*100 whereby Capital Employed (Equity + Preference) + Reserves and Surplus + Long-term Loans -- Fictitious Assets


Capital Employed = Fixed Assets -- Current Liabilities

Returns on capital employed measures the profit, which a firm earns on investing a unit capital. The profit being net result of all operations, the return on capital expresses all efficiencies and inefficiencies of a business. This ratio has a great importance to the shareholders and investors and also management. To shareholders it indicates how much their capital is earning and to the management as to how efficiently it has been working. This ratio influences the market price of the shares. The higher the ratio, the better it is.


Return of Equity

Return on Equity is also known as shareholder's investment; and the ratio establishes relationship between profits available to equity shareholders with equity shareholder's funds.

Return on Equity = Net Profit after Interest, Tax and Preference Dividend/Equity Shareholders' Funds * 100 whereby;

Equity Shareholder's Funds = Equity Share Capital + Reserve and Surplus -- Fictitious Assets

Therefore, Return on Equity judges the profitability from the point-of-view of equity shareholders. This ratio has great interest to equity shareholders. The return on equity measures the profitability of Equity funds invested in the firm. The investors favor the company with higher ROE.

(g.) Earning Per Share

Earnings per share are calculated by dividing the net profit (after interest, tax and preference dividend) by the number of equity shares. Therefore,

Earnings per share = Net Profit after Interest, Tax and Preference Dividend/No. Of Equity Shares.

Otherwise, Earnings per share help in determining the market price of the Equity share of the company. I t also helps to know whether the company is able to use it equity share capital effectively which compare to other companies. It also tells about the capacity of the company to pay dividends to its equity shareholders.


According to Credit and Finance Risk Analysis (2010), the CAMELS approach was developed by bank regulators in the United States as a means of measurement of the financial condition of a financial institution. (Uniform Financial Institutions Rating System established by the Federal Financial Institutions Examination Council). Hence, Credit and Finance Risk Analysis (2010) declares that the acronym CAMELS stands for Capital Adequacy; Asset Quality; Management; Earnings (Profitability); Liquidity and Funding Sensitivity to Market Risk (losses arising from changes in market prices). Further, the Credit and Finance Risk Analysis claims that CAMELS analysis requires financial statements (the last three years and interim statements for the most recent 12-month period); cash flow projections; portfolio aging schedules; funding sources; information about the board of directors; operations/staffing; and macroeconomic information.

Recommendations and Conclusion

Personally, I recommend that both investors, financial institutions and department should analyze their financial statements in four stages i.e. (1) preliminary data adjustments; (2) ratio analysis; (3) assessment of accounting quality; and (4) valuation as recommend by De Mello-e-Souza and…[continue]

Cite This Essay:

"Ratio And Financial Statement Analysis" (2010, April 04) Retrieved October 22, 2016, from http://www.paperdue.com/essay/ratio-and-financial-statement-analysis-1323

"Ratio And Financial Statement Analysis" 04 April 2010. Web.22 October. 2016. <http://www.paperdue.com/essay/ratio-and-financial-statement-analysis-1323>

"Ratio And Financial Statement Analysis", 04 April 2010, Accessed.22 October. 2016, http://www.paperdue.com/essay/ratio-and-financial-statement-analysis-1323

Other Documents Pertaining To This Topic

  • Financial Statement Analysis Adventure Sports Ref Financial

    Financial Statement Analysis: Adventure Sports Ref: Financial Statement Analysis - Adventure Sports Having listened to your predictions regarding Adventure Sports' chances of success, I decided to analyze the company's financial statements so as to determine who amongst you was right. Looking at the company's income statements, it is clear that its profitability has been improving over time. While Adventure Sports had a net income of $1,000 in 2007, the same improved to $7,000

  • Financial Statement Analysis Westpac Wbc Westpac Banking

    Financial Statement Analysis Westpac (WBC) Westpac banking corporation is one of the largest banking organizations in Australia, and the largest bank in New Zealand. Westpac provides arrays of banking and financial services in Austria, which include institutional banking, retail banking, and wealth management services. Established in 1817, Westpac is the first bank established in Australia. Since its formation, Westpac has increased in its strength, and at present Westpac has the market capitalisations

  • Financial Statement Analysis Project

    Financial Statement Analysis The following is an equity research report on Starbucks. The company competes primarily in the quick service food industry, where it holds the #5 market share in the United States, and #1 in its segment of coffee (QSR Magazine, 2011). The company had revenues last fiscal year (ended 10/2/11) of $11.7 billion and net income of $1.245 billion. The current stock price is $43.91, which gives the company

  • Financial Statement Analysis in Order

    This means that Ferrellgas is in risk of default. The company paid more in dividends last year than it earned in cash from operations. In short, Ferrellgas has an unsustainable burn rate. While Inergy had a poor financial position, it was able to tap into capital markets to alleviate any cash crunch -- Ferrellgas has yet to do this and of all these firms is the closest to default. Amerigas

  • Financial Statement Analysis Southwest Airlines

    Managing its fleet. This pertains to the optimization of an Airline's major assets, which is its airplanes, which is measure by its load factor, which is that percentage of an airplane's sets that are sold and actually filled at departure. The Company's load factor continues to increase from 69.5% in 2004, to 70.7% in 2005 to 73.1% in 2006. The Company is able to maximize its fleet by reducing its

  • Wal Mart Financial Statement Analysis WAL MART Financial Statement...

    Wal-Mart: Financial Statement Analysis WAL-MART FINANCIAL STATEMENT ANALYSIS Company Description Wal-Mart Stores Inc. (WMT) is a world largest grocery chain and retail stores. The company operates 8000 stores across three business segments which include apparel, groceries, electronics and small appliances. While the company operates globally, half of the company stores are located in the United States. To complete in the international markets, Wal-Mart also operates its business through subsidiaries in Canada, Argentina, China,

  • HP Financial Statement Analysis There Are Many

    HP: Financial Statement Analysis There are many approaches one could use to analyze the health, stability as well as financial performance of a business entity. One such approach involves a thorough review of the financial statements of the concerned entity. Regarded the leading personal computers manufacturer in the world, Hewlett-Packard - HP amongst other things concerns itself with the manufacture as well as development of both computer hardware and software. In

Read Full Essay
Copyright 2016 . All Rights Reserved