Financial Ratios(Accounting)

Introduction Financial statements obviously play an important role in a fundamental approach to security analysis. Among the items of potential interest to analysts are financial ratios relating key parts of the financial statement. Financial Ratio is a measure of the relationship which exists between two figures shown in a set of financial statements, which indicates performance and financial situation of a company. Financial ratios could assess the profit of investments during the different years, and it can be also used to analyze trends and to compare the firm’s financials to those of other firms. Thus, financial ratios could compare the benefits and risks of different companies, which help investors and creditors to make rational decision. Moreover, this can evaluate the finance condition, operating results and cash flows for a business as well. Financial ratios can be classified according to the information they provide. There are some types of ratios: Liquidity ratios, Profitability rations, Efficiency ratios and Gearing ratios. However, financial ratios relate to both benefits and limitations in evaluating the performance and management of firms. This assignment is going to analyzing the EasyJet plc annual report and accounts in 2003 to discuss the usefulness and limitations of financial ratios.

The ratios analysis is one of the most powerful tools of financial management. It can be computed from any pair of numbers. Given the large quantity of variables included in financial statements, a very long list of meaningful ratios can be derived. A standard list of ratios or standard computation of them does not exist. Financial ratios are used by bankers, investors, and business analysts to assess a company’s financial status. Financial ratio analysis can be used in two different but equally useful ways. Business can use them to examine the current performance of your company in comparison to past periods of time, from the prior quarter two years ago. Frequently, this can help you identify problems that need fixing. Even better, it can direct company attention to potential problems that can be avoided.

Financial ratio plays an important role in financial statements, so there are some benefits of financial ratios. First of all, most of the rations become much more meaningful when used as a basis for comparison, which make a company very easy to compare firms against each other. Besides, it also makes possible comparison of the performance of different divisions of the business. Secondly, financial ratio provides information for inter-firm comparison. It highlights the factors associated with successful and unsuccessful firm, and it also reveal strong firms and weak firms, overvalued and undervalued firms. There are no firm has all the strength points, but ratio analysis can create co-ordination between strength points and weak points. Thirdly, it simplifies the comprehension of financial statements, which is able to illustrate the financial condition of a company by the number. For example, a company’s gross profit in 2011 is 25.3% and in 2012, it is 27.5%. According to this ratio, people can understand whether their company is growing or falling. In addition, financial ratio helps in planning and forecasting as well. This means it could be used to assess the risk factor involved for an investor and predict the bankruptcy of a

company. Thus, financial ratio is an early warning system for businesses that are heading into financial distress.

Although ratio analysis is an extremely useful and powerful tool for the analysis and interpretation of financial statements, but it still has some limitations. Firstly, there are no two companies are exactly the same. This means many large firms operate different divisions in different industries, so it is difficult to find a meaningful set of industry –average ratios. Additionally, inflation might be damage of balance sheets of a company, which will be affected profits of a company as well. After that, small companies tend to pay more debt than large companies, and this will affect the interest coverage ratio formula as a way needs to be explained. Moreover, ratio analysis explains relationships between past information while users are more concerned about current and future information. Therefore, it is only the reference value for the future decision making. What is more, some accounting ratios might be defined in more than one way. This means, different companies may choose different accounting procedure, and each operators have different calculation methods that lead to different interpretations of data. It is very important that users should be aware of this problem when basing important economic decisions on information provided in the form of ratio analysis. Furthermore, a statement of financial position shows only a snapshot of a company’s financial position on a single date, whilst a statement of comprehensive income covers an entire accounting period. Therefore, if the company’s assets and liabilities end of the period are not typical of the period as a whole, any ratio which combines a figure drawn from the statement of financial position with a figure drawn from the statement of comprehensive income might produce a misleading result. Last but not least, financial ratio just able to show the data of company to the analysts or managers, but it cannot explain the problems and deal with them.

EasyJet is a British airline carrier based at London Luton Airport. This is helpful to take a look at what information is obvious from the financial statement. There is some information to interpretation of the ratios, which from the EasyJet plc annual report and accounts in 2013. On the one hand, the non-current assets increased by about 26% (from 2191 pounds to 2964 pounds) between 2009 and 2013. This may be due to the fact that the company invested in some property, such as plane, airline, staffs and so on. Moreover, the number of revenue keep grew up between the 2009 and 2013. Companies use selling products or providing services to achieve the revenue, so the high revenue means the increase of assts or decrease of liabilities in a company. At the same time, there was a significantly increased in the number of profit during the 5 years, which were from 71million pounds in 2009 to 398 million pounds in 2013. Obviously, this means EasyJet Company getting better continually during the year. Return on capital employed is an important ratio expresses a company’s profit as a percentage of the amount of capital invested in the company. This version of ROCE interprets “capital employed” as the total amount of money in the long-term, regardless of whether that money has been supplied by shareholders or lenders. This amount is then compared with the return achieved on that capital. According to the

information from the EasyJet report, there was a remarkable jumped in the number of the return on capital employed from 3.6% to 17.4% during the five years. Generally, the higher the rate of return on capital employed of the company has more growth in the future.

Financial information can be “massaged” in several ways tothe figures used for ratios more attractive. For example, many businesses delay payments to trade creditors at the end of the financial year to make the cash balance higher than normal and the creditor days figure higher too.

these ratios to compare the performance of the company against that of competitors or other members of same industry Performing a ratio analysis on a single set of financial statements is usually a fairly pointless exercise. For example, if the company's inventory turnover ratio of 1 to 4 this year when it was 1 to 3 last year, this means that inventory levels are building in the current year. The increase in the ratio is an indication that sales are slowing or that inventory levels (which are expensive to maintain) are growing. The ratio change alerts the business manager to a pending cash crunch in time to avert it.If you are evaluating two businesses to hire as subcontractors, their respective debt-to-asset ratios will give you an idea about which of these two companies is the more stable choice. The company with a higher debt-to-asset ratio could be more likely to go out of business as a result of defaulting on interest and principal repayments. However, if your primary objective is investing in a business, and you are seeking high returns, the company with the higher ratio may be a better bet. Firms that borrow heavily are high-risk, high-return investments and tend to do either very well or fail spectacularly

A company can burn through its cash reserves quickly during tough economic times or industry contraction. Financial ratios can operate as an early warning system for businesses that are heading into financial distress. Ratios such as the quick ratio (how much money will there be to pay current debts?), gross margin (how much is the company making on every widget it sells?), and accounts receivable ratio (how quickly are sales being paid for?) tell the company's owners if the money is going to run out and how quickly. The sooner the cash flow problem is identified, the sooner it can be corrected.

. The liquidity and non-bank credit ratio are used for assessing the companies going through a hard time. The non-bank ratio is used by a firm where the firm cannot afford to get more credit from banks. This ratio means the greater risk as if the company cannot repay the loan to the bank, it may be charge a higher interest. Therefore, good financial ratio analysing can help business to avoid unnecessary risks.

The positive use of financial ratios has been of two types: by accountants and analysts to forecast future financial variables.