A complete summary of Chapter 3: Ratio Analysis from the Corporate Finance textbook assigned to the module. This includes outlines from the slides as well.
Ratio analysis is done to provide more information “in format” that is easily
comparable over time and between companies and/or industries.
Ratios are more understandable than the financial figures in financial statements and
meaningful relationships between items from financial relationships can be
investigated too.
Requirements for Financial Statements
The primary objective of financial ratio s is to simplify the process of evaluating the
financial position and performance of a company. To achieve this, these ratios need
to meet three requirements:
1. Meaningful
The relationship between items from financial statements must be
logical.
2. Relevant
The value of the ratio must be a true indication of financial
performance.
3. Comparable
Values of ratios must be comparable across industries/companies,
over a period of time, and they must be calculated in a consistent
manner.
Norms of Comparison
Ratios should not be interpreted in isolation. Only by comparing the value of a ratio
with other ratios is it possible to determine if the financial performance and position
of a company is improving or declining. There are 3 norms of comparison for
financial ratios:
1. Conventions
Certain conventions relating to the values of ratios are developed over
time. These may differ between firms and/or industries.
2. Comparison over Time
This comparison helps determine if the company’s financial position
has improved or declined.
3. Comparison between Similar Companies
This comparison helps determine the competitive position of the
company relative to its competitors.
Types of Ratios
Various parties have different objectives when they examine a company’s financial
statements to establish its financial performance and position. There are seven main
categories of ratios:
Profitability Ratios
Profit Margins
Turnover Ratios
Profitability refers to the efficiency with which a company utilizes its capital to
generate turnover.
It is possible to calculate the profitability of different capital items included in a
company’s statement of financial position (a specific revenue-generating asset). The
higher the return on a capital item, the more efficiently it has been used.
There are four main profitability ratios:
Return on Assets (ROA)
The Return on Assets (ROA) measures how efficiently total assets of a company are
utilized to generate revenue.
Profit After Tax
ROA= ×100
Average Total Assets
A higher ROA means that the company is using assets more effectively.
Return on Equity (ROE)
The Return on Equity (ROE) indicates the return generated on the total equity
invested in the company.
Profit After Tax
ROE= ×100
Average Equity
The higher the ROE ratio, the better for equity providers and investors. An increase
in equity could lead to a decrease in ROE if profit after tax remains the same.
Return on Shareholders’ Equity (ROSE)
The Return on Shareholders’ Equity (ROSE) provides an indication of the return
generated on the shareholders’ equity invested in the company.
Profit After Tax−NonControlling Interest
ROSE= ×100
Average Shareholder s ' Equity
The reason for the deduction of non-controlling interest in the ROSE ratio is to
calculate the profit that is available to the preference and ordinary shareholders of
the company.
Return on Ordinary Shareholders’ Equity (ROSHE)
The Return on Ordinary Shareholders’ Equity (ROSHE) focuses only on the portion
of the company’s equity that is provided by ordinary shareholders.
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