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This essay investigates the literature available on ratio analysis. According to the literature, ratio analysis is a tool that is employed by investors so as to undertake a quantitative analysis of data obtained from the financial statements of a given company they may be interested in. The ratios are calculated for the current financial year and then compared to those for the previous year, other companies or even to the average ratio of the industry the company belongs to. This helps the investors to assess the performance of the company in relation to others and therefore it is able to decide whether to invest or not (Edwin and Martin, 1997).
Many ratios can be computed based on the financial statements of a particular company so as to create a picture of its performance, financing, activity and liquidity. Some of these ratios include price-earnings ratio, debt-equity ratio, asset turnover ratio, working capital and earnings per share ratio. These ratios enable the investor to assess the operating performance of the company and thus one can be certain if the assets of the company are used efficiently and in a way that is sufficiently profitable (Hubbard, 2007).
The financial ratios can be classified according to the manner in which they arrived at and also their functions in the analysis of the company. Relating to their construction, financial ratios can be grouped into coverage ratio, return ratio, turnover ratio and component percentage. Coverage ratio is an indicator of the company’s ability to fulfill its obligations it committed to in the past. The return ratio is generally a measure of profitability of the company relative to the resources that are required for production. Turnover ratios provide the proportion of gross benefit relative to the resources used in the process of production. Component percentage, on the other hand, shows the proportion of a component of an item in the financial ratios to the item itself. The other categorization criteria can be on the basis of the need to assess the performance of the company and its financial condition. These will enable one to verify if the assets of the company are used efficiently and also if it will be capable of meeting its obligations in the future. These ratios include liquidity ratio, profitability ratio, activity ratio, financial leverage ratio, shareholder ratio and the return on investment ratio (Tobin, 1958).
The liquidity ratio shows if the company is able to meet its short term obligations and it is based on the assets it holds that are easily liquidated. These assets, which are easily converted to cash in the short run, are the ones that are referred to as the liquid assets and are listed in the financial statements as current assets. Liquidity of a given company can therefore be assessed through the liquidity ratios which include current ratio, quick ratio and the net working capital to sales ratio. The current ratio is the ratio of the amount of current assets to current liabilities. This ratio shows the ability of the company to cover its liabilities with the current assets it holds. The ratio is thus obtained by dividing the value of current assets by the value of current liabilities. From the current statements of Johnson and Johnson holdings, their ratio is 2.4 while that of Procter and Gamble is 0.8 and thus it is safer to invest in Johnson and Johnson as compared to Procter and Gamble (Edwin and Martin, 1997).
The quick ratio is obtained by dividing the value of the current assets less the inventories of a company by its corresponding value of current liabilities. This acts as a measure of the company’s ability to cover its current liabilities with its assets that are most liquid. Considering Johnson and Johnson, their quick ratio is 1.9 while Procter and Gamble has a ratio of 0.4 and so Johnson and Johnson is in a better position to satisfy its current liabilities relative to Procter and Gamble. The net working capital to sales ratio is obtained by dividing the net working capital by the sales of the company. The net working capital can be obtained by subtracting the current liabilities from the current assets of the company. This ratio shows the company’s liquid assets after it has already met its short term obligations as compared to its need for liquidity that is portrayed by the sales in the equation (Hubbard, 2007).
Profitability ratios that are also often referred to as the profit margin ratios, make a comparison between the incomes the company gains and the value of total sales in a given financial year. They give a prospective investor an insight into what constitutes a company’s income. The ratios are usually expressed in the form of a value per dollar of sales. The profitability ratios include the gross profit margin, the operating profit margin and the net profit margin. The gross profit margin is a ratio of the gross profits a company enjoys to the sales it made in that particular financial period. This ratio is an indicator of the amount of every dollar of sale that is left over after the costs incurred in selling the goods. It is obtained by dividing the gross income of the company by the total sales made. In most companies it is given as a percentage, for instance, in Johnson and Johnson the ratio is 73.5% while in Procter and Gamble it is 52.9%. It is thus evident that it is more profitable to invest in Johnson and Johnson as compared to Procter and Gamble. The operating profit margin, on the other hand, shows the portion of the dollar that remains after operating expenses have been deducted. The ratio is obtained by dividing the operating income by the sales made. The higher the operating profit margin is, the more profitable a company is and thus it is able to attract more investors (Edwin and Martin, 1997).
The net profit margin is that profitability ratio obtained by dividing the net income by the revenues of the company or the net profits divided by the sales. This ratio shows the proportion of every dollar that the company keeps as its earnings. This ratio is very important in comparison with companies that operate in the same industry. A higher profit margin is therefore an indication of better control of the costs incurred by the company as compared to the other companies in the industry. In case of Johnson and Johnson, the ratio is 19.9% as compared to Procter and Gamble which has a ratio of 17% showing that Johnson and Johnson keeps more of its revenues compared to Procter and Gamble. Shareholder ratios are also very important ratios that focus majorly on the returns that the shareholders enjoy. The earnings per share is an amount earned per share held by the shareholders in common stock during a specific financial period. This ratio is obtained by the division of the net income that is available to the shareholders by the number of outstanding shares. The basic earnings per share are computed based on the reported earnings and the mean number of outstanding shares while diluted earnings per share are calculated with an assumption that all potential dilutive securities are issued (Hubbard, 2007).
Book value equity per share is the amount of carrying value of common equity per share of common stock. This is calculated by division of the book value of the equity of shareholders by the number of outstanding stock of shares. This value sometimes differs from the market value of equity and in this case the market value of equity becomes a better indicator of the shareholders’ investment in the company. Conversely, the dividend payout ratio is the ratio of cash dividends that are paid to shareholders’ earnings for a given financial year. It is computed by dividing the dividends by the total earnings in that financial period. This ratio is often complemented by the plowback ratio or the retention ratio that is obtained by deducting the dividends from the earnings and then dividing the difference by the total earnings (Edwin and Martin, 1997).
In conclusion, financial ratios are very important in the evaluation of companies by potential investors who are interested in the profitability of the company and security of the invested fund. The ratio analysis is also very crucial in making certain decisions by the management and the board of directors. It also helps the shareholders to make up their minds regarding their share in the company, whether to hold or dispose them.