Financial Ratios and Analysis for Businesses
**Rotation of Total Assets**
RAT = VTAS / TOTAL ASSETS
= 3000/2000 = 1.5 times
Measures the ability to generate transactions (sales), given the total assets. A comparison between companies in the same sector may suggest an insufficient number of operations that should lead the company to increase its level of sales, dispose of some assets, or perform a combination of both.
**Reasons for Debt Management (Leverage)**
The extent to which a company uses debt financing, or its financial leverage, has three very serious implications:
- a) By raising funds through debt, the shareholders can maintain control of a company with limited investment.
- b) Creditors want equity or funds provided by the owners to have a safety margin. When shareholders have provided only part of total financing, the risks of the enterprise are primarily borne by its creditors.
- c) If the company gets a better return on investments financed with loan funds than the interest paid on the same, the return on owners’ capital is increased or leveraged.
**Ratio of Total Debt to Total Assets**
Calculated by dividing total debt (total liabilities) by the total assets of the company.
= VDR / AT
Example = (310 +754) / 2000 = 53.2%
It measures the percentage of funds provided by creditors. Total debt includes both current liabilities and long-term liabilities. Creditors prefer a low debt ratio because the lower the ratio, the greater the protection against losses from creditors in a liquidation. Moreover, owners can benefit from this leverage by increasing earnings. In this case, it demonstrates that creditors have provided more than 50% of the total company funding.
**Times Interest Earned Ratio**
This ratio is computed by dividing earnings before interest and tax by total interest.
EBIT / INTERESTS
Example = 283.80 = 3.2 TIMES
This ratio measures the extent to which operating income can decline before the firm is unable to meet its annual interest costs. Failure to meet this obligation may trigger legal action by creditors of the company, which probably would result in its bankruptcy.
**Ratio of Total Liabilities to Equity**
Calculated by dividing total liabilities by equity.
PT / DC
= 1064/936 = 1.13 pesos
This ratio shows the coverage of capital or shareholder for each dollar financed by foreign creditors.
**Method of Horizontal Analysis**
Compares financial statements of two or more homogeneous periods to determine increases and decreases or changes in the accounts from one period to another.
Importance: Reports whether changes in the activities and the results are positive or negative. Defines which deserve more attention. This procedure is dynamic. Shows variations in absolute numbers, percentages, or ratios.
Analysis Procedures:
- Take two financial statements (balance sheet and income statement) for two consecutive periods.
- Show the accounts of the financial statements analyzed.
- The values are recorded for each account in two columns (the first column is the most recent period).
- Another column indicates increases or decreases (by subtracting the most recent year’s values from the values of the previous year).
- In another additional column, record the percentage of increases or decreases (dividing the base period value multiplied by 100).
The analysis raises questions that serve to make investigations:
- Set a budget of income and expenses to meet cash needs.
- An increase in accounts receivable balance represents an increase in sales.
- A decrease in inventories corresponds to an increase in sales, the lack of goods, or suppliers.
- An increase in furniture or equipment was necessary or appropriate.
- A sale of land takes place in favorable conditions, was auctioned, or sold to pay outstanding debts.
- A decrease in liabilities is due to expired documents.
- An increase in sales is attributable to a rise in prices, increased penetration of the same, or new markets.
- An increase in sales is proportional to an increase in the cost of sales.
- An increase in expenditure is proportional to an increase in sales.
**Profitability Ratios**
These ratios analyze and evaluate the company’s profits with respect to a given level of asset sales to investment from the owners.
**Profit Margin on Sales (RMU VTAS)**
RMU VTAS is calculated by dividing the profit or net income (net ING) available to shareholders (acc) by sales.
RMU VTAS: Net income / Shareholders (acc)
Displays the utility obtained by each dollar of sales.
**Basic Earning Power Ratio**
Basic Earning Power: BEP
BEP: Earnings before interest and taxes
This reasoning shows the potential of the company’s assets before the effect of taxes and leverage (debt interest).
**Return on Total Assets**
ROA is calculated by dividing net income (A) available to shareholders (after interest and taxes) by total assets.
ROA: Net income / Before tax (AT)
= 113.50 / 2000 = 5.67%
Measures the return on total assets after taxes and interest.
**Return on Equity**
ROE is calculated by dividing income or net income available to shareholders by equity.
ROE = Net income / Equity
= 113.50 / 936 = 12.12%
Measures the return on equity or return on shareholder investment.
**Method of Trend Analysis**
Trend analysis emerges as a complement to the previous method (increase and decrease) to make comparisons between more than two periods, especially when one of those periods has atypical situations in the behavior of the business. Trend analysis can be applied to any item of the financial statements.
**Method of Budget Control**
Set procedures and resources used with skill and ability, serve the administration to plan, coordinate, and control through budgets, all the functions and operations of a business, so you get the maximum performance with minimum effort.
**Importance and Usefulness of Budgetary Control**
A budget is the action plan developed for the company, taking into account research, studies, and statistics. It establishes a link between business activities with the general trend and facilitates timely decisions regarding the direction that productivity should follow. It increases the finance function since it directs the use of capital and channels efforts toward utility. Knowing how much more money is needed allows the use of more convenient and effective funding.
Budgeting can be defined as a plan expressed in quantitative terms. The process of preparing a budget is planning in every sense of the word, and the budget is the resulting plan. This plan should possess objectivity, structure, and flexibility.
Budgets at companies allow:
- Establish definite goals to achieve by providing methods to be observed to reach them.
- Promote the necessary cooperation or partnership for general plans to be executed.
- Establish control means to verify if obtaining this as planned and also allows adaptation of corrective measures.
**Cash Flow Statement**
It is the statement that shows the movement of income and expenses and the availability of a certain date. The first step to prepare a cash flow statement is to identify those balance sheet items that have provided cash and those that have used cash during the years. This is done through the development of a statement of origin and use of resources. First, determine the change to each account in the balance sheet, and then the change is recorded as a source or as an application of resources.
Rules of the Origins of Resources:
- Any increase in a liability account or capital.
- Any decrease in an asset account.
Resource Applications:
- Any decrease in liabilities or stockholders’ equity.
- Any increase in an asset account.