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

5. Significance of Accounting Ratios in Financial Analysis

Chapter 5 Significance of Accounting Ratios in Financial Analysis This chapter involves structuring accounting ratios in a hierarchy and highlights possible limitations of the application of accounting ratios in financial analysis. This chapter includes the following sections: • Hierarchy of Accounting Ratios • Limitations of Accounting Ratios Ratios are fractions of numerators and denominators with various acceptable formulae and methods of calculation. Ratio analysis serves as a guide for users of financial statements to assess and evaluate the relative financial performance and strength of a corporation. Accounting ratios measuring the individual aspects of a corporation, such as profitability, liquidity, operating efficiency, leverage and investment performance are discussed in Chapter 4. Analysts may see ratios as a metal detector showing the whereabouts of the treasure in the ground. Still, they need to dig for the treasure by asking intelligent questions. Analysing accounting ratios from financial statements points analysts to the right direction and helps to indicate whether or not the corporation is on track. Hierarchy of Accounting Ratios To give a more comprehensive picture, analysts may piece together all the relevant ratios in a hierarchy of accounting ratios and consider the relationships amongst them. Grouping accounting ratios in a hierarchy 88 Financial Analysis in Hong Kong (Second Edition) helps to illustrate how individual ratios fit together and how the corporation’s decisions and activities as measured by individual accounting ratios interact to produce an overall return to the shareholders, i.e. ROCE. A hierarchy of ratios identifies the main determinants of ROCE, as illustrated in Figure 5.1. Following a hierarchy from ROCE to a series of subsidiary ratios demonstrates the disproportionate effect on the ROCE by small changes in subsidiary ratios. Analysts need to identify the changes in these ratios in order to understand the underlying performance of the corporation. ROCE can be enhanced through either of its two immediate subsidiary ratios, i.e. the maximization of net profit margin and/or the optimization of asset turnover. We have already considered net profit margin and asset turnover in Chapter 4. To maximize net profit margin, a corporation usually increases the price or volume sold and applies effective cost controls. Widening gross profit margin and/or increasing sales against the same (or lower) cost base can help the maximization of net profit margin. To enhance asset turnover, a corporation may utilize its assets (fixed assets and/or for working capital) more efficiently. In particular, asset-intensive corporations depend heavily on their assets to generate profits, so that driving the assets harder and increasing their productivity can push up the profitability. Some changes of subsidiary ratios are generated from one-off improvements, such as the recovery of overdue debts in a substantial sum Figure 5.1 Hierarchy of accounting ratios Return on Capital Employed Net Profit Margin Gross Profit Margin Fixed Asset Turnover Inventory Turnover Days Debtor Turnover Days Creditor Turnover Days Working Capital Ratio Asset Turnover 5. Significance of Accounting Ratios in Financial Analysis 89 releasing tied-up working capital and reducing debtor turnover days. On the other hand, some changes may be caused by measures giving sustainable benefits, such as the introduction of a new technology into the production process to increase fixed asset turnover and to trim down cost base. Improving ROCE may be achieved through its subsidiary ratios by ways of boosting gross profit margins, controlling costs, utilizing fixed assets more effectively and/or minimizing working capital. Analysts should be aware of the relationships amongst accounting ratios and implications on other aspects. Reducing working capital to improve a corporation’s ROCE may deteriorate the liquidity ratios. For example, a reduction of inventories or debtors together with an increase of creditors can put pressure on liquidity ratios, in particular both current ratio and acid-test ratio would be adversely affected. Accounting ratios may be aligned with the corporation’s missions, strategies and overall budget. An overall budget on an annual basis consists of many subsidiary budgets, such as sales forecast and production schedules as well as financial position, profit-or-loss and cash flow budgets. A sales forecast refers to a projection of the volume and price of sales a corporation makes in the forthcoming year. A production schedule, for a corporation manufacturing its own products, seeks to plan for the right amount of raw materials, the efficient use of production facilities and the appropriate manpower to manufacture the products meeting the sales forecast’s requirements. A financial position...