PROFESSIONAL ACCOUNTING COLLEGE OF THE CARIBBEAN (PACC)

Ratio Analysis / Perfor an!e A""raisal

PAPERS# $%&/ '/ &%'/ &%(/ )%*/ )%+ LECTURER# AN,RE PAL-ER This particular topic has widespread examinable topics and is regularly examined. There are four (4) main ways in which analysis of the data can be done. These include: USING TREN, OR .ERTICAL ANAL/SIS ($) This will involve the comparison of the entitys performance over a given period, say !" years. This method can be critici#ed from the point of view that there is no external reference point to which the results could be compared. (&) IN,USTR/ A.ERAGE CO-PARISON This method re$uires that the detailed results for a particular period be compared to a ban% of similar ratios established from companies of the same si#e and operating in the same business sector. These similar ratios are available from agencies such as &nterfirm 'omparison (&(') in the )* + ,unn + -radstreet in the )./. These results are usually available based on the payment of a subscription cost. The primary benefit of this type of analysis is that the ratios are developed from the results of several companies and this gives a more representative set of ratios when compared to 0ust one company. 01estions in t2is area 1s1ally entail eit2er# (a) .electing the better performing company for investment purposes (b) /n investor see%ing advice on either investing in the company or assessing their investment to date1 or. (c) / financial institution may wish to finance an entitys operations and re$uires expert advice. ((rom a professional) ()) USING THE HORI3ONTAL ANAL/SIS APPROACH This method re$uires comparing an entitys performance for a particular period (2!3 yrs) with that of an e$uivalent entity in the same time period. The primary limitation lies in differences in the other company which might ma%e the comparative entity to be either out! or under! performing the entity being analysed. .uch factors include accounting policies, mngt, technological developments, age of e$uipment, etc. (') USING THE CO--ON SI3E APPROACH This method converts the actual 4 value results to a percentage value of total sales. This means that each ratio is reflected 2

(a) /s a 5 value1 and (b) That 5 is a 5 of sales. T2e li itations 2ere are any in!l14in5 (a) )sing relative values (5) distorts the absolute performance (b) /rriving at misleading interpretations because of the relative outcome (5) General Points &t is critical in performance analysis to assess the 6CONTE7T8 in which the $uestion or study is posed. 6ay attention to the .ITAL clues given in the $uestion. (or example, clues may be given outlining different factors such as: ($) RELATE, PART/ TRANSACTIONS (a) 7oans advanced on non!commercial terms (b) The supply of goods to an entity on very favourable price and credit terms (c) /n entity benefiting charge free from head office expertise (&) FACTORS AFFECTING CO-PARABILIT/ (a) 'reation of policies that affect operations via lower sale prices to stimulate demand. (b) / general revaluation of fixed assets facilitates a higher capital employed value leading to: (i) / reduction in 89':1 and (ii) ;o change in profitability and operating capacity (c) )sing debtor!factoring strategies. This leads to shorter debtor collection periods but this is not due to internal improved credit control procedures. (d) .ale and leasehold of ma0or fixed assets. This will impact on the entity as follows: (i) 7owers the operating assets1 (ii) &mproves asset utili#ation (e) 'hoice of different accounting policies eg. .traight 7ine vs. 8educing -alance ,epreciation <erger or ac$uisition accounting for business combinations CO--ON CRITICIS-S OF ANS9ERS :xaminers usually comment on the lac% of understanding of the ratios provided. .tudents do the calculations and state the obvious but this =9->&9).? does not explain the cause of the variation. :g. .toc% turnover period has increased from 4@ days to A@ days. This is a statement of (/'T. To gain mar%s, a student has to provide a clear explanation of what has caused the change, say a change in fashion in the clothing sector or the purchasing of excess stoc% at a bargain price from a competitor closing down. 8atios usually allow more than one correct answer in terms of the interpretation and the clues in the $uestion usually provide pointers as to the direction going forward.

E7A-INATION APPROACH (2) ,o the relevant calculations under the appropriate heading and be consistent in the ,efinition of the components in the ratio. (3) /void duplication of ratios eg. .toc% turnover + .toc%holding periods ( ) &nterpret the ratio obtained. Bhile the calculations provide some mar%s, the ma0ority of mar%s will come from the 6INTERPRETATION8. (4) 6ic%up any easy interpretation mar%s eg1 (i) 8apid determination in li$uidity (ii) .ignificant capital items purchased and minimal increase in sale (lower asset turnover) ANS9ER STRUCTURE / typical $uestion in this area re$uires analysis in %ey areas such as: (a) 689(&T/-&7&TC D /..:T )T&7&./T&9; :g. 89':, E65, ;65, /sset Turnover (b) 7&F)&,&TC + /'T&>&TCDB98*&;E '/6&T/7 :g. 'urrent + Fuic% 8atios, ,ebtor, 'reditor + .toc%holding period G (B98*&;E '/6&T/7 8/T&9.) (c) E:/8&;E + '977/T:8/7 .:')8&TC D (&;/;'&/7 .T8)'T)8: These ratios are critical as they could mean the difference between: (i) /ccessing and having continuing financial support from a third party ((inancial institution) (ii) The rate charged on such advances! the greater the ris%, the higher the interest rate. NB (d) NB /s with several categories of ratios, there is no one best answer. 9ne has to consider1 (i) The industry of the operation (ii) &ndustry practices (iii) 'omposition of balance sheet assets (iv) .easonality -A:OR LI-ITATIONS OF RATIOS &;>:.T<:;T 8/T&9. :g. 6D:, :6., :/8;&;E. C&:7,, ,&>&,:;, C&:7, + ,&>&,:;, '9>:8

(2) 8atios are open to manipulation, eg. Bhere creative accounting has ta%en place such as operating leases being used rather than finance leases G i.e. 'reative accounting. (3) Bhilst ratios may give indications of inefficiency, it lac%s the full explanation as to the cause and this will re$uire a full investigation. ( ) The choice of accounting policies will impact on comparability, for example, how realistic is it to compare a firm with revalued assets and one that has not revalued. (4) The particular accounting practices adopted such as the use of factoring as against an internally managed receivables. ,ebtors collection period for the firm is meaningless and cannot be compared. (") The impact of inflation distorting comparisons over time. (A) The inconsistent definition of an accounting ratio eg. (or example, is gearing debt / e$uity or debt D debt H e$uity. (I) The impact of seasonality on the balance sheet figure eg. Jigh retail stoc%s at 'hristmas yDe > a <ay yDe. (K) 8atios are inter!related and this has to be fully understood G for example, 7abour inefficiencies could be caused by a lac% of capital investments and not by the s%ill resources available. (L) 8atios ignore special circumstances, for example the impact of high oil prices on the manufacturing entity. (2@) 8atios are incapable of dealing with ;9;! F)/;T&T/T&>: aspects of an entitys performance. (22) )sing norms such as the current ratio being between 2." and 3.2 as being desirable is good but is );8:/7&.T&' /. /77 -).&;:..:. are different eg. / construction D manufacturing entity would have a low 'urrent 8atio whilst a supermar%et would have a high ratio as it has few ,ebtors. CONCERNS 9HEN USING INTER;FIR- CO-PARISONS (2) These ratios are averages and are sub0ect to large variations. 6roducers of such information try to overcome this limitation by providing the results in $uartiles. (3) The lac% of specificity in terms of the sector in which the company is included. The type of products or mar%ets may be different thereby affecting comparability. ( ) 'ompanies of different si#es operate under different economies of scale and this may not be reflected in the industry averages. (4) The lac% of use of = '9T:8<&;9).? year!end periods impact on the overall assessments as this is affected by matters of seasonal trading and the attendant balance sheet averages. .ome providers try to group items with similar year!ends but this is not a complete solution.