Financial Ratio Analysis: Real-life cases

How do you compare their performance and potential?

This is where financial ratio analysis comes in handy. Financial ratio analysis is the technique of comparing the relationship (or ratio) between two or more items of financial data from a company’s financial statements. It is mainly used as a way of making fair comparisons across time and between different companies or industries.

Financial ratios are numerical expressions that indicate the relationship between various financial statement items, such as assets, liabilities, revenues, and expenses.

Financial ratios can help you evaluate various aspects of a company’s financial health, such as its profitability, liquidity, solvency, and efficiency.

By using financial ratios, you can gain insights into a company’s strengths and weaknesses, as well as its opportunities and threats.

You can also use financial ratios to set benchmarks and goals and to monitor and improve performance.

There are many types of financial ratios, but they can be broadly grouped into the following categories:

• Profitability ratios measure how well a company generates income from its operations. They indicate how efficiently a company uses its resources to produce profits. Some examples of profitability ratios are gross profit margin, net profit margin, return on assets, and return on equity.
• Liquidity ratios measure how easily a company can meet its short-term obligations with its current assets. They indicate how well a company manages its cash flow and working capital. Some examples of liquidity ratios are the current ratio, quick ratio, and cash ratio.
• Leverage ratios measure how much a company relies on debt to finance its activities. They indicate how well a company can handle its debt obligations and how risky its capital structure is. Some examples of leverage ratios are debt-to-equity ratio, debt-to-asset ratio, and interest coverage ratio.
• Activity ratios measure how efficiently a company utilizes its assets and liabilities. They indicate how well a company manages its inventory, receivables, payables, and fixed assets. Some examples of activity ratios are inventory turnover, receivable turnover, payable turnover, and asset turnover.

Using these ratios, you can compare Company A and Company B on various dimensions and decide which one is a better investment option.

1. For example, you can compare their profitability ratios to see which one has higher margins and returns,
2. their liquidity ratios to see which one has more cash and less debt, their leverage ratios to see which one has lower financial risk and higher solvency,
3. and their activity ratios to see which one has faster turnover and better asset management.

Of course, financial ratio analysis is not the only tool you should use to evaluate a company.

You should also consider other factors, such as the company’s strategy, vision, mission, values, culture, competitive advantage, industry trends, market conditions, customer satisfaction, and social responsibility.

Financial ratio analysis is a useful technique, but it should be used with caution and in conjunction with other methods of analysis.

These are some financial ratios, their formulas, and their importance. Here are some examples:

• Current ratio = Current assets / Current liabilities

?-This ratio measures a company's liquidity, or its ability to pay off its short-term debts with its current assets.

- A higher current ratio indicates a better liquidity position.

- A current ratio of 1 or more is generally considered acceptable, but it may vary depending on the industry and the nature of the current assets and liabilities.

• Debt-to-equity ratio = Total debt / Total equity

?- This ratio measures a company's leverage, or how much it relies on debt to finance its activities.

- A higher debt-to-equity ratio indicates a higher financial risk and a lower solvency.

- A debt-to-equity ratio of 1 or less is generally considered preferable, but it may depend on the industry and the cost of debt and equity.

• Gross profit margin ratio = Gross profit / Net sales

- This ratio measures a company's profitability, or how much it earns from its core operations.

- Gross profit is the difference between net sales and cost of goods sold.

- A higher gross profit margin ratio indicates a higher efficiency and a lower cost of production.

- A gross profit margin ratio of 20% or more is generally considered good, but it may vary depending on the industry and the pricing strategy.

• Asset turnover ratio = Net sales / Average total assets

?- This ratio measures a company's efficiency, or how well it utilizes its assets to generate sales.

- A higher asset turnover ratio indicates a higher productivity and a lower asset intensity.

- An asset turnover ratio of 1 or more is generally considered desirable, but it may differ depending on the industry and the type of assets.

• Price-to-earnings ratio = Market price per share / Earnings per share

- This ratio measures a company's market value, or how much investors are willing to pay for its earnings.

- A higher price-to-earnings ratio indicates a higher growth potential and a higher investor confidence.

- A price-to-earnings ratio of 15 to 25 is generally considered reasonable, but it may change depending on the industry and the market conditions.

How Financial Ratios Impact?

• Financial ratios are important tools for analyzing and comparing the performance, liquidity, solvency, and efficiency of different companies or industries.
• However, if the financial ratios are calculated incorrectly, they can lead to misleading or inaccurate conclusions and decisions. Here are some examples of real-life cases where wrong financial ratio calculations had negative consequences:

- In 2001, Enron Corporation, a US energy company, collapsed due to accounting fraud and manipulation of financial statements.

Enron used various techniques to inflate its revenues, assets, and profits, and to hide its debts and losses. As a result, Enron's financial ratios, such as return on assets, debt-to-equity, and earnings per share, were artificially high and gave a false impression of its financial health and performance.         

Investors, analysts, and creditors relied on these ratios and were deceived by Enron's fraudulent reporting. When the truth was revealed, Enron's stock price plummeted and the company filed for bankruptcy, causing huge losses for its stakeholders and damaging the reputation of the accounting profession.

- In 2008, Lehman Brothers, a US investment bank, filed for bankruptcy due to excessive leverage and exposure to subprime mortgages. Lehman Brothers used a technique called Repo 105, which involved selling some of its assets at the end of each quarter and buying them back at the beginning of the next quarter.

This way, Lehman Brothers reduced its apparent leverage ratio, which is the ratio of total debt to total equity, and made its balance sheet look less risky.         

However, this was a temporary and deceptive measure, as Lehman Brothers still owned the assets and the liabilities associated with them. When the subprime mortgage crisis hit, Lehman Brothers could not sell its assets or raise enough capital to repay its debts and had to declare bankruptcy, triggering a global financial crisis.

- In 2012, Hewlett-Packard (HP), a US technology company, acquired Autonomy, a UK software company, for $11 billion. However, HP later discovered that Autonomy had inflated its revenues, margins, and growth rates by using improper accounting methods and transactions. As a result, HP had to write off $8.8 billion of the acquisition value and accused Autonomy of fraud.

Autonomy's financial ratios, such as revenue growth, gross profit margin, and operating profit margin, were overstated and did not reflect its true performance and value.         

HP relied on these ratios and paid a premium price for Autonomy, without conducting proper due diligence. The acquisition turned out to be a costly mistake for HP and led to a legal dispute with Autonomy.?

These are some of the real-life cases where wrong financial ratio calculations resulted in serious financial and legal problems for the companies involved. These cases show the importance of verifying the accuracy and reliability of the financial data and the methods used to calculate the financial ratios, and of using multiple sources and perspectives to evaluate the financial performance and position of a company.

In summary, financial ratio analysis is a method of comparing financial statements to evaluate a company’s liquidity, profitability, efficiency, and solvency.

It can help you make informed decisions about investing in a company, as well as monitor and improve its performance.

However, financial ratio analysis has its limitations and should be used carefully and critically.

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