Introduction
Companies and other business organizations exist in order to offer benefits to their stakeholders. From year to year, the management, shareholders, customers, lenders, employees and the government are interested in the trend of their business’ performance so as to make important decisions. The financial statements are usually not effective in giving information sufficient to make decisions. An analysis of the financial information from one year to the next is necessary in order to provide important information that can be used for decision making by the various stakeholders.
Ratio analysis is a means of making comparisons between the financial variables in the statement of incomes and the statement of financial position (Robinson, Munter, & Grant, 2003). The ratios calculated are an indication of an organization’s performance by comparing the current year’s ratio with those of previous years or comparing the ratios with a benchmark (Brealey, Myers, & Marcus, 2007).
Purpose of ratio analysis
Ratio analysis of a company’s financial statements is performed for a variety of reasons. The main reason for ratio analysis is to show the performance of the company (Siddiqui & Siddiqui, 2005). It shows the company’s financial condition in the present year, thus giving an indication of whether a fair return on investment has been generated. Secondly, ratio analysis is an important tool for comparison of performance of the current year relative to the previous year, showing whether the company’s performance has improved or deteriorated (Siddiqui & Siddiqui, 2005).
By observing the trend, investors and other stakeholders can make decisions regarding their future engagement with the company. Finally, ratio analysis highlights the company’s areas of strengths and weaknesses (Brealey, Myers, & Marcus, 2007).
Classification of ratios
There are various ratios that are derived from a company’s statement of comprehensive income and the statement of financial position. These ratios are classified into five main classes; liquidity ratios, leverage or gearing ratios, activity ratios, profitability ratios and investors’ ratios. Liquidity ratios are computed in order to measure the ability of the organization to settle its current debts. Leverage or gearing ratios are used to measure the extent to which a company uses funds from external sources to finance its operations (Brealey, Myers, & Marcus, 2007).
Activity ratios, also referred to as turnover ratios, are used to measure the efficiency with which a company utilizes its assets in order to generate sales revenue. Profitability ratios are used to show the effectiveness of managers by indicating how successful they are in generating profits for the company. Finally, investment or equity ratios are used to evaluate the overall score of the company, for example, to determine the company’s theoretical value of a share and the effect of a right’s issue on the company’s earnings per share.
Ratio analysis for two healthcare companies
The table is an analysis of two ratios for two healthcare companies; The University of North Carolina Health Care System and Northwestern Memorial Healthcare and Subsidiaries. The analysis is based on the financial statements of the companies for the years ended 30th June, 2013 and 31st August, 2013 respectively. The two ratios to be examined are the current ratio, which is a liquidity ratio, and the net profit margin; a profitability ratio. The ratios have been derived from the financial statements of the two companies. The financial statement extracts have been given below.
The ratios calculated above indicate that the University of North Carolina Health Care system has a current ratio of 1.84 while that of Northwestern Memorial Healthcare and Subsidiaries is 1.35. This shows that for every $1 short-term debt in each of the healthcare companies, there is $1.84 and $1.35 in the two companies respectively to settle the debt. These ratios show that the two companies are financially strong and are thus able to meet their short-term debts with no difficulties.
However, University of North Carolina is more financially sound as compared to Northwestern Memorial Healthcare and Subsidiaries as shown by the higher ratio. The current ratio is usually compared with a benchmark that varies from organization to organization. The benchmark is normally between 1.5 and 3.0, although some researchers recommend a current ratio of 2 (Thierauf & Hoctor, 2003). This shows that in as much as the two health organizations are financially sound, they might fall below the threshold.
The net profit margins of the University of North Carolina Healthcare system and Northwestern Memorial Healthcare and Subsidiaries for the years ended 30th June, 2013 and 31st August, 2013 respectively were 3.8% and 7.7%. This is an indication of the ability of the managers of the two companies to effectively generate sales while checking on the expenditure of the organizations so as to make profits from their operations. The results show that the University of North Carolina Healthcare system made a net profit, which was 3.8% of the actual sales made during the financial year.
When compared with the previous year’s results which showed a 5.8% gross profit margin, the results for 2013 were a reduction of the ratio; an indication of inefficient management of expenses during the year. A similar conclusion is made about Northwestern Memorial Healthcare and Subsidiaries where the net profit is 7.7% when expressed as a percentage of sales. However, this was a superior financial performance than the previous year’s financial return of 5.5%. This shows superior performance during the year ended 31st August, 2013.
Limitation of ratio analysis
Despite the usefulness of ratios as seen in this report, they have several limitations. First, ratios seldom provide answers to questions. Instead, they only help the analyst to ask the right questions (Brealey, Myers, & Marcus, 2007). Secondly, the benchmarks provided may not reflect the best basis of comparing results.
Moreover, comparing ratios between two financial years where market conditions change significantly is not objective and might lead to the wrong conclusions. The factors that affect the financial results and hence ratios include competition, inflation, political instability, seasonality, etc.
References
Brealey, R. A., Myers, S. C., & Marcus, A. J. (2007). Fundamentals of Corporate Finance. New York: McGraw Hill Companies.
Robinson, T. R., Munter, P., & Grant, J. (2003). Financial statement analysis : a global perspective. New York: Pearson Education.
Siddiqui, S. A., & Siddiqui, A. S. (2005). Managerial economics and financial analysis. New Delhi: New Age.
Thierauf, R. J., & Hoctor, J. J. (2003). Smart business systems for the optimized organization. Westport: Praeger.