Financial analysis (Part 2). Ratio Analysis
In the first part of a series of posts on financial analysis, we looked at the main components of companies' financial statements, the data from which serve as "raw material," i.e., the primary input for further work of financial analysts.
Next, Roman Kornyliuk, Doctor of Economic Sciences and financial analyst at YouControl, explains why reading the Balance sheet, Income Statement, and other forms of financial statements is not always enough to understand the financial status of a company and what indicators will help you know the situation.
Due to the heterogeneity of the companies studied in the market, for financial analysis purposes, it is not the absolute amounts of individual accounting items that are of greater importance but their ratio to each other, which may be quite normal in economic terms or abnormal and indicate imbalances and risks of the activity.
When analysing the financial statements of companies, analysts most often use ratio analysis, the results of which, in turn, can be the basis for ready-made business decisions and used as input data for further stages of research, including scenario analysis, stress testing, clustering, classification, linear, logistic regressions, scoring models, and others.
Ratio Analysis is the use of interdependencies and comparison of various financial statement items to assess a company's financial status and results.
At the initial stages of financial analysis, financial ratios (relative indicators) are traditionally used, calculated based on the company's financial statements, which directly indicate the company's performance and financial stability. According to their economic essence, indicators can be classified into the following groups: liquidity ratios, solvency ratios, profitability ratios, and business activity ratios.
Liquidity ratios express a company's ability to pay off its liabilities quickly. You should consider several liquidity indicators (Current Ratio, Cash Ratio, Quick Ratio, acid test, and others) to analyse this indicator.
Examples of liquidity indicators:
- Cash Ratio = Cash and cash equivalents/Current liabilities.
- Quick Ratio = (Cash and cash equivalents + Short-term investments + Short-term accounts receivable)/Current liabilities.
- Current Ratio (Cover Ratio, Working capital ratio) = Current assets/Current liabilities.
- Cash to Assets Ratio = Cash and cash equivalents/Assets.
Practical significance: liquidity shows how much your counterparty is (or will be) provided with available cash assets and how quickly it can repay its debts without raising additional resources or selling other assets. The higher the liquidity ratio, the better because if you have sold your products to this company, you want to know whether the promised funds will be received and how much money the company receives or plans to receive on average during the year. Be sure to pay attention to the previous liquidity dynamics and the date of calculation of the last indicator: liquidity can decline much faster than other indicators.
Solvency ratios indicate a company's ability to repay long-term financial liabilities over more than one year. Solvency ratios include, among others, the equity ratio (Equity-To-Asset ratio) and the Non-current asset to Net Worth ratio. Other solvency indicators include:
Debt ratio = Liabilities/Assets (or Debt/Assets)
Debt-to-Equity Ratio = Debt/Net Worth
Financial Leverage = Assets/Net Worth
Interest Coverage Ratio = EBIT / Interest Paid
One of the subsets of solvency ratios is debt burden indicators, such as the Net debt-to-EBITA ratio – Earnings Before Interest, Taxes, Depreciation and Amortization.
Practical significance ☝️: debt means that a company may not have free cash resources, so it is not worth providing goods on a deferred-payment basis, as they may not be paid for. Over-indebted companies are the first to go bankrupt. Therefore, understanding the solvency of counterparties is essential for creditors and suppliers, who risk getting late payments or not getting paid at all for goods they have sold. A high debt burden means a company is more exposed to business risks, as current operating profits are insufficient to repay existing debts.
Profitability ratios reflect a company's ability to generate revenues and profits. An example of this group of indicators is the Net Profit Margin, which is the gross profit to revenue ratio. This ratio shows the actual profitability of the company's business. The change in the margin compared to the previous year will tell you how the company's pricing policy and efficiency have changed. Among other profitability indicators, the following are popular:
Return on equity (ROE) = Net income/Net Worth.
Return on assets (ROA) = Net income/ Assets.
Gross Profit Margin = Gross profit/Revenue.
Operating Profit Margin = Operating profit/Revenue.
Practical significance ☝️: the higher the profitability, the higher the declared profits of the company compared to its size (in assets, capital, revenue, and others). The classic business segment does not welcome partnerships with companies that record losses (negative financial results) year after year. Even if you know that the owners are deliberately underreporting their profits to pay fewer taxes, you should look closely at such a partner and ask clarifying questions about their business model and actual financial situation.
Business activity ratios
Business activity ratios show the efficiency of a business, i.e. the rate at which a company turns its assets into cash. Turnover ratios show how many times assets come in and out of the company during a period. For example, the Inventory Turnover ratio reflects how many times inventory was created and sold during the period. Examples of business activity indicators:
Inventory Turnover = Cost/Inventory (average annual)
Receivables Turnover = Revenue/ Receivables (average annual)
Payables Turnover = Total supplier purchases/ Payables (average annual)
Total Assets Turnover = Revenue/Assets (average annual).
Working Capital Turnover = Revenue/Working Capital (average annual)
Days Inventory Outstanding (DIO), the average time for the production and sale of inventory = 365/Inventory Turnover
Days Receivables Outstanding (DRO) = 365/Receivables Turnover
Days Payables Outstanding (DPO) = 365/Payables Turnover
Operating Cycle = DIO + DRO
Cash Conversion Cycle = DIO + DRO – DPO
Practical significance ☝: payables turnover is especially important: if your client has a longer turnover than similar companies in the industry, you should consider whether, instead of smooth operating activities, you will have to engage in debt collection activities, diverting precious resources to recover unpaid funds from the buyer.
Despite the leading role of ratio analysis, this approach has some drawbacks, including the variety of ratios, the reasonable selection and use of which requires time, sufficient experience and high professionalism from both the analyst and the users of the analysis.
One way to address this problem is to use scoring methods in financial analysis based on calculating a consolidated and integral scoring indicator based on many of the above ratios. Another way is to have professional analysts prepare individual credit ratings using sophisticated techniques combining quantitative and qualitative data analysis approaches.
Integral scoring indicators
Integral scoring indicators based on open data combine the set of necessary ratios and other financial indicators based on a previously developed and tested algorithm. For example, FinScore is an integral scoring index of a company’s financial sustainability calculated by the analytical department of YouControl. As of January 2022, this index is based on 20 financial indicators that comprehensively describe the company’s liquidity, solvency, profitability and business activity.
Thanks to the scoring algorithm developed on the basis of modern methods of machine learning, logistic regression modelling and financial analysis, the FinScore index confirms its high signal ability to predict the probability of company bankruptcy from year to year – firms with the worst indicators have gone bankrupt far more frequently than their competitors over 2011-2022. The value of the FinScore index can vary from 1 (D - minimum financial sustainability) to 4 (A - maximum financial sustainability), depending on the values of the company’s financial indicators. Hence the results of the calculations are intuitive for users.
Financial analysis of business groups
The financial analysis of business groups based on the ratio and scoring methods has its specifics stemming from the dispersion of financial statements each group member prepares separately. Therefore, for holding companies, it is better to study the general consolidated financial statements for the entire group of companies as a whole if such consolidated statements exist, which is rare in Ukraine. The parent company of a business group itself may not be actively involved in operations, so if it is analysed separately from affiliated companies, it may not always be correct to make conclusions about the total revenue of the business group. Moreover, some group companies may be operationally unprofitable, others may be profitable, and some may have a debt burden that is de facto distributed among the holding members. In practice, the distribution of financial indicators among the members of a business group depends not only on objective external factors or actual internal financial sustainability but also on the specifics of the group's business structuring in terms of pricing policy, as well as numerous regulatory, security and tax factors. Therefore, financial analysis of business groups based on open data is a non-trivial task that requires a comprehensive approach and consideration of the financial condition of all or at least key participants.
Financial analysis based on open data is a vital area of using public information in the form of published corporate financial statements. Effective use of modern techniques of ratio and scoring financial analysis is the key to solving several significant economic problems faced by representatives of the business community of Ukraine:
- Banks suffer from an increase in the share of non-performing loans and financial monitoring penalties due to unreliable customers
- The corporate sector still faces problems with the accumulation of receivables and disruption of contracts
- Tender buyers are trying to improve the identification of unreliable contractors with low financial stability
- Potential foreign investors note an apparent lack of comprehensive information about Ukrainian companies.
The progress and transparency in the disclosure of financial statements in the open data format at the macro level can make business decisions based on financial data analysis more balanced and rational, thereby contributing to the sustainable economic development of Ukraine.