Financial ratio

I. Introduction

The concepts, uses and limitations of financial ratio analysis are explained further down. Some of the basic techniques of calculating ratio analysis are examined. The brief history of Northumbrian Water Group public limited company and their future objectives are enclosed. Financial statements are used to calculate and explored using ratio analyses from investor's point of view. Finally limitations of financial ratio analyses are discussed.

II. Ratio

It has been said that we must measure what you expect to manage and accomplish. Without measurement, you have no reference to work with and thus, you tend to operate in the dark. One way of establishing references and managing the financial affairs of an organization is to use ratios. Ratios are simply relationships between two financial balances or financial calculations. These relationships establish references so company or a business can understand how well financial performance is. Ratios also extend traditional way of measuring financial performance i.e. relying on financial statements. By applying ratios to a set of financial statements, company or a business can better understand financial performance.

According to Aidan Berry and Robin Jarvis (1997p. 255)

“A ratio R is quantity A divided by quantity B:

R=A / B

In essence a ratio is merely a shorthand notation for the relationship between two or more things.

It is the relationship that it is expressing that must be understood. Without that understanding the ratio, no matter how precisely calculated or sophisticated, is meaningless.”

There are four main types of ratios which can be applied to analyze financial statements. They are liquidity ratios, efficiency ratios, operating ratios and investment ratios.

III. Types of ratio analyses and their purpose

Liquidity ratios The benefit of analyzing liquidity ratios is evaluating the solvency, financial stability and management of working capital of the company or a business. Definition of liquidity ratios is the proportion of total assets that are readily convertible into cash that a clearing bank must maintain in order to repay deposits on demand. According to Anil B.Roy Chowdhury (1978, p.2) “ The word “Liquidity” means conversion of assets into cash during the normal course of business and to have a regular uninterrupted flow of cash to meet outside current liabilities or current obligations as and when due and payable” Common liquidity ratios are current ratio, quick ratio and operating cash flow ratio. ● Current ratio The current ratios are mainly used to give an idea of the company's ability to pay backits short-term liabilities (debtandpayables)with its short-term assets (cash, inventory, receivables). The current ratio can give a sense of the efficiency of a company's operating cycle or its ability to turnits product into cash. Companies that have trouble getting paid on their receivables or have long inventory turnover can run into liquidity problems because they are unable to alleviate their obligations.

● Quick ratio

The quick ratio is a stringent test that indicateswhether a firm has enough short-term assets to cover its immediate liabilities without selling inventory. For many businesses inventory cannot be converted into cash quickly. Therefore quick ratio excludes inventories from any measure of liquidity.

● Operating cash flow

Operating cash flow ratio measures how well current liabilities are covered by the cash flow generated from a company's operations in the short-term. Using cash flow as opposed to income is sometimes a better indication of liquidity simply because, as we know,cash is how bills are normally paid off.

Efficiency ratios

We will analyze efficiency ratios to evaluate the overhead structure of company. Efficiency isalso a good measure ofprofitability.

● Debt ratio

Debt ratio indicates what proportion of debt a company has relative to its assets. The measure gives an idea to the leverage of the company along with the potential risks the company faces in terms of its borrowings.

● Equity ratio Equity ratio used to help determine how much shareholders would receive in the event of a company-wide liquidation.

● Debt to Equity ratio Debt to Equity ratio indicates who has the major share in the business at a particular date. The comparison is between shareholder's funds and creditors funds.

● Interest Cover Ratio Interest Cover ratio is assesses the relative safety of interest payment by measuring the number of times interest payable on borrowing is covered by the available profits. Operating Ratios Operating ratios are used to assess the operating performance of a company.

● Net Profit Margin According to Atrill & McLaney (2005 p. 207) “The net profit margin relates the net profit of the business to the sales revenue generated for the same period. Net profit represents the difference between sales revenue and cost of sales.”

● Return on capital employed Return on capital employed measures the percentage return on the total investment of funds in the business. This provides useful information about management's effectiveness in generating revenue from recourses

● Total Assets Turnover Total assets turnover measures utilization of assets in generating sales.

● Debtor's turnover Debtor's turnover is short-term liquidity measure used to quantify therate at which a co mpanypays offits suppliers.Accounts debtor's turnover ratiois calculated by taking the total purchases made from suppliers and dividing it by the average accounts payable amount during the same period.

● Stock Turnover This Ratio indicates the impact or relation between number of times or quantum of inventory goes out and the quantum goods added to inventory

Investment Ratios Investment ratios provide valuable information to actual or potential shareholders. These ratios are also of interest to management, since a company depends upon potential investors for further funds for expansion.

● Earnings per share Earnings per share ratio relate the earnings generated by the business available to shareholders, during a period to the number of shares issued. This ratio is important to the investors for two reasons: - It gives the investor some idea of security of future dividends. - Investors can check to ensure that management are not paying out all earnings but are pursuing a prudent policy of plugging back some part of the annual profit.

● Price: Earnings Ratio Price/earnings ratio is ascertained by a comparing the market price of an ordinary share with the earnings per share. This may be expressed as so many years purchase of the profits.

● Dividend Yield Dividends declared are always based on a percentage of the nominal value of issued share capital.

IV. Northumbrian Water Group public limited company and company's objectives

Northumbrian Water Group's principal activity is providing water, waste water management and related services. Northumbrian Water operates as one of the ten regulated water and sewerage business in England and Wales. This division operates in the north east of England, where it trades as Northumbrian Water, and in the south east of England, where it trades as Essex and Suffolk Water. The Water business also provides environmental monitoring services, analysis and technical consultancy to major industrial groups, environmental regulators and local authorities throughout the United Kingdom and Ireland. In addition to its water services, it also provides overseas aid funded project work in developing countries through a number of funding agencies.

In recent years the water industry has been affected less by the current recession than many others but we are not immune. The decline in industrial demand for water has had an impact on revenue. Many of customers are finding it more difficult to pay their bills while the energy costs rose significantly. Against that difficult and uncertain background they submitted the Final Business Plan for 2010-2015 to Ofwat. The plan proposes an average real annual price increase over the five years of 3.4% to support a £1.27 billion investment program - an increase of 20% on the amount being invested in 2005-2010. Ofwat will use the plan to set draft price limits in July 2009. Source: www.nwg.co.uk

As from data given in financial statement of Northumbrian Water Group public limited company we will conduct a quantitative analysis to analyze the operating performance, solvency, financial stability, shareholders return and financial structure.

V. Financial performance of Northumbrian Water Group public limited company for the last 2 years and consolidation of ratio analysis

Liquidity ratio analyses of Northumbrian Water Group public limited company:

Ratio

Definition in words

Year 31.03.2009

Result

Year 31.03.2008

Result

Current ratio

Current Assets / Current Liabilities

404.3 m/215m

1.9:2

422.7m/293.1m

1.4:2

Liquid ratio

Current Assets-Inventory / Current Liabilities

404.3m-3.2m/215m

1.9:1

422.7m-3.4m/293.1m

1.4:1

Operating cash flow ratio

Cash Flow from Operations / Current Liabilities

368.9m/215m

1.7 :1

381.8m/293.1m

1.3:1

Efficiency ratio analyses of Northumbrian Water Group public limited company:

Ratio

Definition in words

Year 31.03.2009

Result

Year 31.03.2008

Result

Debt ratio

Total debt / Total Asset

3622.4m/3879.8m

0.9

3365.7m/3857.5m

0.9

Equity ratio

Shreholder's Equity / Total Asset

255m/3879.5m

7%

490.1m/3857.5m

13%

Debt to Equity ratio

Total Debt / Shareholder's funds

3622.4m/255m

14.2

3365.7m/490.1m

6.9

Interest cover

Profit before Interest / Interest

273.6m/183.5m

1.8

277.8m/173.5m

1.6

Operating ratio analyses of Northumbrian Water Group public limited company

Ratio

Definition in words

Year 31.03.2009

Result

Year 31.03.2008

Result

Net profit margin

Trading Profit after Interest and Tax / Sales x100

(11.9m)/694.1 x100

-1.71%

158.3m/670.4m 100

23.61%

Return on capital employed

Trading Profit / Tangible Net Assets x100

273.6m/257.4m x100

10.6%

277.8m/491.8 x100

56.5%

Debtors turnover

Sales / Average Debtors

694.1m /150.4m Average debtors Year 2009 147.8m+152.9m / 2= 150.4m

4.6 times

670.4m /159.3m Average debtors Year 2008 152.9m+165.6 / 2= 159.3m

4.2 times

Stock turnover

COGS / Average Stock

420.5m/ 3.3m Average stock Year 2009 3.2m+3.4m / 2= 3.3m

127 times

392.6m/3.6m Average stock Year 2008 3.4m+3.7m / 2= 3.6m

109 times

Investment ratios of Northumbrian Water Group public limited company:

Ratio

Definition in words

Year 31.03.2009

Result

Year 31.03.2008

Result

Earnings per share

Earnings before extraordinary items but after deducting tax, minority interest and preference dividend / Number of ordinary share

(11.9m)/518.6m

-£0.02 or -2.29p

158.3m/518.6m

£0.305 or 30.52p

Price : Earning Ratio

Market Price per share / Earnings per Share

258.69p/12.36p 258.69p Current market price 29.01.2010

21 years

235.00p/11.52p 258.69p Market price 30.01.2009

20 years

Dividend Yield Ratio

Dividend per share / share price x100

12.36p/218.25p

5.7%

11.52p/349.25p

3.2%

The interpretation of the information above NWG shows that company's solvency, financial stability and management of a working capital is very good managed and improved according to figures in 2009. Company's inventory management is under control, as proportion of inventory in current assets is very low. Returns shareholders and lenders will receive in wide liquidation dropped. From data given in debt ratio, proportion of debt to assets is stable for the last two years and if a wide liquidation required company will be able to cover all debts borrowed, analysis show that 0.9:1 return will be received. Shareholders return dropped to 7% in 2009 from 13% in 2008. Proportion of total liabilities to shareholders funds increased to 14.2 in 2009 from 6.9 in 2008. This is a sign of increase in company's borrowings. As the borrowings increased, interest cover ratio of the company slightly increased as well from to 1.8 times in 2009 to 1.6 times in 2008. The high borrowing but a slight change in interest is due to policy change as all borrowings are on fixed rate now. Regardless of recession company increased the cost of product, but it did not help to increase the profit. For £1sales revenue company's loss was £0.017 in 2009 where in 2008 for £1 sales revenue company's profit was £0.24. This may be caused by 50%increase in electricity which was not expected. Dramatic decline occurred as in 2009 there was only 10.6% return on capital employed where in 2008 it was 56.5%. This, the decline in return on capital employed was caused partly by the company incurring higher inventory purchasing costs relative to revenue and partly thought higher operating expenses to revenue. The debtor's turnover slightly increased in 2009 to 4.6 times from 4.2 times in 2008. Stock turnover is increased to 127 times in 2009 from 109 times in 2008. These increases above may be because of efficient management of debtors and debtors are more liquid also efficient management of inventory because more frequently the stocks are sold, the lesser amount of money is required to finance the inventory. As a result of recession total return on total profit available to shareholders decreased as company is in loss in 2009 return was negative -2.29p per share where in 2008 it was 30.52p per share. The price /earnings ratio increased to 21 years from 20 years therefore stock market's view in financial prospect of the company is positive and indicates that market believes that the NWG has a bright future and they are recovering. Return on investment increased to 5.7% in 2009 from 3.2% in 2008. This is a NWG board's decision to maintain a progressive dividend policy with real increases of around 3% per annum. Recession and loss in the company did not affect most of the financial operations, performance and the management is very efficient. NWG is recovering as share prices are going up and it is a good time to invest in the company, because return on investment is 5% which is higher that most high street banks.

VI. Limitations of ratio analysis

The choice of analysis depends on their use, but in some cases the data may not be disclosed. There are limitations on accessing financial information. Analysis of the financial performance of NWG been calculated above but the major causes are not knows as the required information is not disclosed. There are not agreed definitions of the terms used. Comparison of the ratio analysis can be done only if companies are similar and operating in the same sector of the market. Ratio analysis does not take account of non-financial factors. Therefore, not all aspect of the companies can be taken into account. For example do the companies have big plans for future, a good reputation, a strong customer base, reliable suppliers and loyal employees? Those listed cannot be calculated using financial analysis. Despite these drawbacks ratio analysis is a very good method for interpreting financial statements of the company.

VII. Conclusion

Techniques for analyzing the financial statements been explained. This type of analysis is widely used by management, investors and competitors. There is wide range of ratio analysis that can be calculated and main of them are described. The profitability, efficiency, operating activities and investment ratios are examined. All those ratios above applied to calculate and interpret the financial performance of Northumbrian Water Group public limited company. Return on investment and benefits of investing in NWG are looked at. Limitations of ratio analysis in calculating and interpreting financial performance are discussed.

References:

Aidan Berry and Robin Jarvis (1997). Accounting and Business Context, 3rd edition. London: International Thomson Business Press

Anil B. Roy Chowdhury (1978). Financial Ratios and Working Capital. Calcutta: B.C DE for Eastern Law House LTD

Northumbrian Water Group public limited company website www.nwg.co.uk

Peter Atrill & Eddie McLaney (2005). Financial Accounting for Decision Makers, 4th edition. England: Pearson Education Limited

Bibliography:

Horngren, et al., (n.d.). Introduction to Management Accounting 14th edition. New Jersey: Person Parantice Hall

J.O. Harrigan (1967). An Evaluation of Financial Ratio Analysis. Chicago: Illinois

Pauline Weetman (2006). Financial Accounting an Introduction, 4th edition. England: FT Prentice Hall

www.accountingformanagement.com

www.bized.co.uk

www.investopedia.co.uk

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