Financial Analysis in Hong Kong: Qualitative Examination of Financial Statements (2nd edition) for CEOs and Board Members

4. Accounting Ratios

Chapter 4 Accounting Ratios This chapter gives an overview and brief interpretation of accounting ratios from various perspectives and includes the following sections: • Ratios from Accounting Records and Financial Statements • Profitability Ratios • Liquidity Ratios • Leverage Ratios • Investment Ratios • Accounting Ratios from Listed Corporations’ Financial Highlights As a concept in mathematics, ratios refer to the proportional relationship between two (or more) items, expressed in terms of numbers or percentages. By placing one number over another, a ratio can be computed from any pair of numbers. The top number is called the numerator, and the bottom number is the denominator. We use ratios every day. We compare our weight to the average measurement by relying on a sample of individuals at our age with their total weights divided by the sampled number of individuals. In reading the economy’s unemployment rate, we check the number of people out of work against the total workforce. Ratios measure the size of one item in relation to another item and provide a sense of how changing one item may affect the other one. Grasping this simple concept is vital to analyse what goes on behind the numbers. 58 Financial Analysis in Hong Kong (Second Edition) Ratios from Accounting Records and Financial Statements Accounting ratios are based on accounting books and records and extract relevant figures from corporations’ financial statements. By focusing attention on certain key aspects of a corporation’s financials, accounting ratios generally attach meaning and significance to figures which are not readily apparent from financial statements. For example, if a corporation increases its annual turnover from $1,000 million in 2011 to $1,100 million in 2012, it is simpler and probably more intuitively helpful to state that the turnover has gone up by 10% (= 100% × [1,100 – 1,000] / 1,000). If a corporation earns $20 million in 2012, the size of this profit figure on its own has no significant meaning unless we relate the profit to the size of the corporation in question, or to the amount of profit that it earns in 2012 or before. Similarly, the fact of a corporation’s current assets of $150 million or $15 million means very little by itself until we relate this amount of current assets to the size of the corporation’s turnover, or the value of its total assets or current liabilities. Accounting ratios help prompting questions about a corporation and give analysts a means of condensing the relevant information into a few key ratios. Based on the accounting data in financial statements, analysts calculate various accounting ratios and use them to assess and review the certain key aspects of the corporation in question, such as performance, efficiency, solvency and stability. Analysts and investors often use ratio analysis to appraise the financial condition of a corporation and to identify its strengths and vulnerabilities. Many banks provide loans on the condition that the corporation maintains certain minimum ratios such as net worth, debt-to-equity ratio and acidtest ratio (each of these is considered in subsequent sections). These conditions are usually found in loan covenants, and failing to maintain these minimum ratios puts the corporation technically in loan default. Other financiers such as venture capitalists may set achieving certain ratios as “milestones” calling for more capital, e.g. a new trench of financing would be added as soon as the corporation achieves 50% gross margins for two consecutive quarters. The same basic ratio can often be calculated in a number of different ways, and the method chosen by analysts and other users depend on 4. Accounting Ratios 59 individual preferences and established practices. Most corporations publish certain what they regard as most important and relevant ratios to their business in the annual report. However, other than earning per share, formula or calculation basis varies between corporations. Even the industry benchmark ratios vary according to their sources. Unfortunately, details of how the industry benchmark ratios are computed are often not made public. Possible inconsistent formula or calculation basis inevitably hinders the effectiveness of accounting ratios in financial analysis, and limitations of accounting ratios are considered in Chapter 5. Each ratio must have a particular purpose and focus on one (or more) particular aspect(s). Therefore, it is important to understand why a ratio is being calculated in order to interpret its logics and implications. In this chapter, we look at four main categories of accounting ratios: • profitability ratios; • liquidity ratios...