Financial Ratio Analysis.

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. Financial Ratio Analysis

.1 Introduction

As part of the system of financial control in an organisation, it will be necessary to have ways of measuring the progress of the enterprise, so that managers know how well the company concerned is doing. The financial situation of a company will obviously affect its share price.

The answer to some of the following questions can be obtained from accounting reports produced by the company:

i. Is the company profitable?

ii. Is the company growing?

iii. Does the company have satisfactory liquidity?

iv. Is the company's gearing level acceptable?

v. What is the company's dividend policy?

The usual way of interpreting accounting reports is to calculate and then to analyse certain ratios (Ratio Analysis). The key to obtain meaningful information from ration analysis is comparison (that is, comparing ratios over time within the same business to establish whether the business is improving or declining, and comparing ratios between similar businesses to see whether the company you are analysing is better or worse than average within its own business sector.

Ratio analysis on its own is not sufficient for interpreting company accounts, and there are other items of information, which should be looked at. These include the following:

i. Comments in the Chairman's report and the director's report

ii. The age and nature of the company's assets

iii. Current and future developments in the company's markets, at home and overseas

iv. Recent acquisitions or disposals of a subsidiary by the company

v. The cash flow statement (where required by FRS 1)

1.1.1 Limitations and Strength of Financial Ratios

Financial Ratios are used to compare actual results with something else. The comparison may be against a budget or a desire target, or perhaps against a previous period's results in order to detect trends. On the order hand, an entity's results may be compared with the results of another entity using ratios in order to ascertain whether current actual results are better or worse than those of other similar business units.


* On their own, they do not provide information to enable managers to gauge performance or make control decisions. It is necessary to provide budgeted or targeted ratios, ratios of previous accounting periods, or ratios of other companies or divisions, as a tool for comparison.

* Ambiguity arises when defining the ratios used. For example, should earnings be 'before tax' or 'after tax'?

* Ratios compared over a period of time at historical cost will not be properly comparable where inflation in price has occurred during the period, unless an adjustment is made to the ratios to make allowance for price level differences.

* The ratios of different companies cannot be properly compared where each company employs different accounting policies.


Despite of the limitations, it provides a useful tool for management, shareholders and any interested parties to assess the performance of the business. Other strengths are as follows:

* It summarises relationships and results relevant to an organisation's performance.

* It allows year-to-year performance comparison.

* It allows performance comparisons of organisations in the same industry.

* It allows trends to emerge and hence predictions to be made.

.2 Analysis Report for Jin Yang Ltd



To: Mr Tom Tan, Managing Director

From: Accountant

Date: 7 May 2002

Subject: Performance appraisal for the years 1998 to 2001

We have based on the summarised accounts obtained for the years 1998 to 2001 and interpreted the accounts using Financial Ratios. We have prepared an appendix of ratios (see Appendix 1), a trend analysis report (see Appendix 2) and a set formulas of the ratios used (see Appendix 3).

Profitability Ratios

The Return on Capital Employed (ROCE) and the Return on Owners' Equity (ROE or ROOE) has gradually increased by 4.7% from 15.77% in 1998 to 20.47% in 2001 and by 4.67% from 8.03% in 1998 to 12.70% in 2001, respectively. It shows that the business is profitable with it resources fairly utilised, as the higher ROCE the more profitable the business.

The Operating Profit margin only increases marginally by 0.02% from 11.62% in 1998 to 11.64% in 2001, despite of the dip by 0.64% in 2000. Although Sales has increase by 33% since 1998, the cost has also increased substantially. The increase in cost could also be due to the increase in the number of employees being employed, which leads to an increase in employees' remuneration.

It will be good if we are given the Gross Profit (GP), so that we could calculate that GP margin and differentiate whether the increase in cost is due to an increase in Cost of Sales or Operating expenses. The profit margins measure the quality of the business, as the higher the margin the higher quality of the business. On the other hand, low margin could be due to high cost of production, where it cannot enjoy the economic of scale and could also be due to intense competition from competitors, where it may need grant sales discount to increase it's competitiveness.
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The Net Profit margin has increase by 1.3% from 5.92% in 1998 to 7.22% in 2001, despite of the dip by 0.14% in 2000. The increase is due reduction in corporate tax by 11% in 2001. In overall, the company has an average profitability.

Liquidity Ratios

The Current ratio and Quick ratio have shown substantial decreases by 0.53% from 1.92% in 1998 to 1.39% in 2001 and by 0.37% from 1.02% in 1998 to 0.65% in 2001, where the ideal ratios level should be at least '2' and '1' respectively.

Both ratios measure the business ...

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