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Understanding Financial Ratios for Analysis of Company Performance

To analyse the financial performance of a company comprehensively, it is not enough just from the numbers listed in 4 types of financial statements, the number will be more meaningful when compared to something (in the form of ratios),

To see the magnitude relatively and to be easier than, both in time-series with the same ratio in the previous year and with the performance of competitors or industry average performance in the same sector in the reporting year.

There are 5 categories of financial ratios as follows:

  • Liquidity Ratios (consisting of Current Ratio and Quick Ratio)
  • Activity Ratios (consisting of Inventory Turnover, Average Collection Period, Average Payment Period and Total Assets Turnover)
  • Debt Ratios (consisting of Debt to Equity Ratio, Times Interest Earned Ratio/ Interest Coverage Ratio, and Fixed Payment Coverage Ratio)
  • Profitability Ratios (consisting of Gross Profit Margin, Operating Profit Margin, Net profit Margin, Earning Per Share (EPS), Return On Assets (ROA) and Return On Equity (ROE)
  • Market Ratios (consisting of Price/Earnings (P/E) Ratio and Price to Book (P/B) Value

 

Why We Need Ratios

In order to more easily understand the importance of using ratios in analyzing financial performance, I try to describe it through the short story below.

Suppose you are asked to compare the profits of two companies in the same period, Company A net profit of $ 100, and Company B with a net profit of $ 150. “Which is better?”

With that information alone, of course you will answer “Company B for sure.”

but then you may ask “but, uh, first, to be fair, let’s compare the profit judging by the percentage against the total sales?”, 

Then you are given additional information, Company A sales revenue in that year is $ 500, while Company B total revenue are $ 900.

When compared to its sales revenue, company A’s net profit margin is =$100 / $500 = 20 %, while company B = $150 / $900 = 16.7%.

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“Oh if it’s better Company A, although nominally profits are smaller, but on a percentage margin basis, Company A margin is higher”

Okay, to be more apple to apple, what about the size of the two companies, let’s compare the profits of the two companies with their total assets.

You have additional information, that The Total Assets of Company A is $2,000, while The Total Assets of Company B is $2,500

Oh, it turns out, Return On Assets (ROA) Company A = $100 / $2,000 = 5%, while Company B = $150 / 2,500 = 6 %

“If you look at the comparison of profits with assets, Company B won…”

Apparently, although Company B’s profit margin is thinner than Company A, Company B is more able to optimize the use of its Asset Assets to generate profits than Company A.

“Um, are you satisfied here?” 

Later, let’s see also from the point of view of the comparison of the profits of the two companies compared to their own capital (owner’s equity).

You get information Owner’s equity Company A is $1,000, while Owner’s equity Company B is $2,000 (it turns out Company A has more capital coming from debt than Company B yes..).

With this data, you calculate Company A’s Return on Equity (ROE) = $100 / $1,000 = 10%, while Company B ROE = $150 / $2,000 = 8%.

You know, it turns out that ROE Company A is higher than Company B, this means that with less capital alone, Company A can make better profits than Company B.

So, which company won? 🙂

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If you have $1,000, would you prefer to donate it to Company A or Company B?

To be clear, the above story I present in the following simple table:

why we need ratio
why we need ratio

With a short story illustration and table above, hopefully we can better understand why we need to use ratios to be able to analyse the performance of a company more comprehensively.

This is the second of my three articles on the Company’s Financial Statements The other two articles are:

Now let’s go back to discussing the type of financial ratio, the ratio is obtained from the numbers on financial statements, especially income statements and balance sheets.

To facilitate the discussion, we show back the Income Statement and Balance Sheet of the Imaginer Company “danieel.id Company” (which we have discussed in detail in the previous article: Understanding the 4 Types of Company Financial Statements)

Income Statement
“danieel.id Company” Income Statement 2019

 

Balance Sheet
“danieel.id Company” Balance Sheet 2019

Let’s start discussing one by one the ratios of these:

if there are any questions, suggestions or suggestions, please submit through the comments field at the bottom of this article

A. Liquidity Ratios

1. Current Ratio

Current ratio is a ratio to measure a company’s ability to meet its short-term obligations.

The formula is as follows:

current_ratio

From the Balance Sheet “danieel.id Company”, the Current Ratio of this company in 2019 is : $ 2,487 / $985 = 2.53

Current Ratio of more than 1 means the Company’s Current Assets are sufficient to meet its short-term liabilities

2. Quick Ratio

Quick Ratio or also called acid-test ratio, almost the same as the current ratio, except in this ratio, inventory values are excluded from the calculation.

Inventory is excluded from the calculation of this ratio due to its low liquidity, this is caused by:

Some types of inventory are semi-finished items (work in progress) that are not easy to sell.

Some inventory (finish good material), usually sold on credit, so it does not immediately become cash.

The Quick Ratio formula is as follows:

quick ratio

From the Balance Sheet “danieel.id Company”, the Current Ratio of this company in 2019 is: ($2,487-$560) / $985 = 1.96

 

Summary Liquidity Ratios

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The greater the current ratio and quick ratio indicate the better the company’s liqudity.

But of course this value has an optimum point, because for companies hoarding too much cash is also not good in terms of productivity and return on assets, because the company loses the opportunity (potential loss) to rotate the money in the company’s machine to make more profit.

Liquidity ratios also vary ideally depending on the size of the Company, the level of volatility of its business and how it accesses short-term financing (such as short-term credit from banks).

To further assess whether the company’s liquidity ratio ratio is good enough or not, let’s compare it time-series with the previous year’s performance and the average liquidity ratios of similar industries in the reporting year (2019).

Liquidity Ratios
“danieel.id Company” Liquidity Ratios 2019

From the table above we can see that when compared to the previous year, both the current ratio and the quick ratio “danieel.id Company” increased nilanya, and also higher when compared to the average liquidity ratio of similar industries.

This shows that in terms of liquidity, the Company can be said to be healthy and has more than enough cash to meet its short-term obligation obligations.

Now let’s continue discussing Activity Ratios on the following page (page 2)

This post is also available in: Indonesian

Daniel
Danielhttps://danieel.id
Lahir di Palembang pada bulan November 1981, saya menyelesaikan S1 di Jurusan Teknik Kimia Universitas Sriwijaya, dan S2 Master of Business Administration (MBA) di Sekolah Bisnis Management Institut Teknologi Bandung (SBM-ITB). Bekerja di salah satu BUMN dan tinggal di daerah Jakarta Selatan.

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