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The use of accounting ratios in decision making

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par Lambert KABERA
National University of Rwanda - Bachelor Degree 2009
  

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2 4 Types of analysis using accounting ratios in decisions making

2 4 1 Analyzing Liquidity

Liquid assets are those assets that can be converted into cash quickly. The short-term liquidity ratios show the firm's ability to meet short-term obligations. Thus a higher ratio (#1 and #2) would indicate a greater liquidity and lower risk for short-term lenders. The Rule of Thumb (for acceptable values): Current Ratio (2:1), Quick Ratio (1:1) While high liquidity means that the company will not default on its short-term obligations, note that by retaining assets as cash, valuable investment opportunities might be lost. Obviously, Cash by itself does not generate any return only if it is invested will we get future return. In quick ratio, we subtract the inventories from total current assets since they are the least liquid (among the current assets. (Prof. Phill Russeil, 2003)

Since the cash is the most liquid asset, a financial analyst may examine the ratio of cash and its equivalent to current liabilities. Trade investment and marketable securities are equivalent of cash therefore they may be included in the computation of current ratio. (I.M Pandey, 1995: 112).

1. Current Ratio = Total Current Assets/Total Current Liabilities

2. Quick or Acid-test Ratio = Total Current Assets - Inventories /Total Current Liabilities

3. Cash ratio = Cash + Marketable securities/Current liabilities.

These ratios show the extent to which a firm is relying on debt to finance its investments/operations and how well it can manage the debt obligation. Obviously, if the company is unable to repay its debt or make timely payments of interest, it will be forced into bankruptcy. On the positive side, use of debt is beneficial as it provides valuable tax benefits to the firm. Note total debt should include both short-term debt (bank advances + current portion of long-term debt) and long-term debt (such as bonds, leases, and notes payable). (Prof. Phill Russeil, 2003).

Asset-Equity Ratio or Leverage Ratio= Assets/Shareholder's Equity

This shows firm's reliance on external debt for financing (or the degree of leverage). Any number above 100% shows that the company relies on external debt for financing some of its assets. If the number equals 100%, it implies that the assets are fully financed by the shareholders.

Some analysts tend to use the Debt ratio (given by total Debt/total assets) or Debt/Equity ratio given by total long-term debt/equity). These ratios also show company's reliance on external sources for financing its assets. (Prof. Phill Russeil, 2003)

1. Total Debt ratio = Total Debt/Total assets

2. Debt-Equity Ratio = Total Debt/Equity

3. Long-term Debt to capital = Debt/Debt + Equity

For a lender, more important than the degree of leverage is the firm's ability to service the debt and this is captured in the following ratio.

2 4 3 Analyzing Sales and Profitability

Profitability is a relative term. It is hard to say «what percentage of profits» represents a profitable firm as the profits will depend on the product life cycle, competitive conditions in the market, borrowing costs, expense management. Analysts will be interested in the (historical and forecasted), the set of ratios here include some of the traditional earnings based performance

measures such as ROS, ROA, ROI, and ROE. For a better understanding of growth rates, it will be useful to know the «real growth rate» as opposed to «nominal growth rate». For example, it is quite possible that the sales growth rate figures are impressive due to inflation (rather than an increase in the number of items sold). (Prof. Phill Russeil, 2003).

The following are ratios selected to analyse profitability and sales ;

1. Sales Growth Rate = {(Current year sales - last year sales)/last year sales} * 100

2. Expense analysis = various expenses /Sales

3. Gross Margin/Sales = Gross Profit/Total Sales

4. Operating Profit/Sales = Operating Profit/Net Sales

5. EBIT to Sales = EBIT/Net Sales

6. Return on Sales (ROS) or net profit ratio = Net Income/Net Sales

7. Return on Investment (ROI) = Net Income/Total Assets

8. Return on Assets (ROA) = Net Income/Total Assets

9. Return on Equity (ROE) = EAT/Shareholders' Equity

10. Payout ratio = Cash Dividends/ Net Income

11. Retention ratio = Retained Earnings/Net Income

12. Sustainable growth rate (SGR)= ROE * Retention Ratio

It is useful to disaggregate the ROE figure into three elements as follows to get a better insight 13 ROE = {Net Income/Sales} * {Sales/Assets} * (Assets/Equity)

The above formulation clearly shows that if management wishes to improve their ROE, they need to improve profitability, efficiently use the assets, and optimize the use of debt in their capital structure.

SGR shows how much the company will grow in the future if some of the key ratios remain the same as in previous years. It is useful to disaggregate the sustainable growth rate (SGR) as follows.

? SGR = f (Profitability, Asset Efficiency, Leverage, Dividend policy)

· SGR = Return on Sales * Asset turnover ratio * Leverage * Retention ratio

· SGR= (Net income/sales) * (sales/assets) * (assets/equity) * (RE/net income)

2 4 4 Analyzing Efficiency

These ratios reflect how well the firm's assets are being managed. The inventory ratios show how fast the inventory is being produced and sold. Ratio #1 shows how quickly the inventory is being turned over (or sold) to generate sales higher ratio implies the firm is more efficient in managing inventories by minimizing the investment in inventories. Thus a ratio of 12 would mean that the inventory turns over 12 times or the average inventory is sold in a month. Some High ratio by itself does not mean high level of efficiency as high ratio could also mean shortage. Ratio #2 is referred to as the «shelf-life» i.e. how many days the inventory was held in the shelf. Ratio #3 shows how much sales the firm is generating for every currency unit of investment in assets, naturally, higher the better. However, note that this ratio is biased (as assets are listed at historical costs while sales are based on current prices). Ratios #4 and #5 show the firm's efficiency in collecting from credit sales. While a low ratio is good it could also mean that the firm is being very strict in its credit policy, which may drive away some customers. Ratios #6 and 7 focus on efficiency in making payments. (Prof. Phill Russeil, 2003)

1. Inventory Turnover = Cost of Goods Sold/Average Inventory

2. Days in Inventory = (Average Inventory/Cost of Sales)*365

3. As sets turnover = Net Sales/Total As sets

4. Receivables Turnover = Credit Sales/Accounts Receivables

5. Average Collection period = (Accounts Receivable/Net Sales)*3 65

6. Accounts Payable turnover = Purchases/Accounts Payable

7. Days AP outstanding = (Accounts Payable/Cost of Sales)*3 65

2.4.5 Multiple Discriminant Analysis

The use of MDA helps to consolidate the effect of a set of ratios by looking at a number of separate clues (ratios to sickness or failure).It would be more useful to combine the difference ratios into a single measure of the probability of sickness or failure (bankruptcy).

According to (Altman E., 1968: 589-609), as the first man to apply discriminant analysis in finance for studying bankruptcy, his study helped in identifying five ratios that were efficient in predicting bankruptcy.

The model was developed from a sample of 66 firms half of which went bankrupt. He derived the following discriminant function:

Z = 0.01 2X1+0.0 1 4X2+0.03 3X3+0,006X4+0.999X5 Z= discriminant function score of a firm;

1. X1= net working capital/total assets (%);

2. X2= retained earning/total assets (%);

3. X3= EBIT/total assets (%);

4. X4=market value of total equity/book value of debt (%);

5. X5= sales/total assets (times)

Alman, established a guideline Z score which can be used to classify firms as either financially sound a score above 2.675 or a headed towards bankruptcy a score below 2.675. The lower the score, the greater the like hood of bankruptcy and vice versa.

2.4.6 Trend Analysis

Using the past history of a firm for comparison is called trend analysis. By looking at the trend in a particular ratio, one sees whether that ratio is failing, rising, or remaining relatively constant. From this, a problem is detected or good management is observed. (Charles H.GIB SON, 1989: 123).

2.5 The Components of Decision Making 2.5.1 Decision environment

decision environment would include all possible information, all of it accurate, and every possible alternative.

However, both information and alternatives are constrained because the time and effort to gain information or identify alternatives are limited (Robert Version, 1998).

2.5.2 Decision Model

Decision model can be used to represent a productive system in mathematical terms. A decision model is expressed in terms of performance measures, constraints, and decision variables. The purpose of such a model is to find optimal or satisfactory values of decision variables which improve systems performance within the applicable constraints. These models can then help guide management decision making. (ROGER G. SCHROEDER, 1985: 7).

2.5.2.1. The effects of using a decision model

A decision model has great impact on the profits of the company. It forces the management to rationalize the depreciation, inventory and inflation policies. It warns the management against impending crises and problems in the company. It specially helps in following areas:

- The management knows exactly how much credit it could take, for how long (for which maturities) and in which interest rate. It has been proved that without proper feedback, managers tend to take too much credit and burden the cash flow of their companies.

- A decision model allows for careful financial planning and tax planning. Profits go up, non cash outlays are controlled, tax liabilities are minimized and cash flows are maintained positive throughout.

- As a result of all the above effects the value of the company grows and its shares appreciate.

The decision model is an integral part of financial management. It is completely compatible with financial ratios analysis and derives all the data that it needs from information extant in the financial statements of the company.

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