Ratio Analysis as Tool of Financial Statements

Qantas Virgin blues

 Type of ratio 2006 2007 2008 2009 2010 2006 2007 2008 2009 2010 Industry averages Debt ratio 0.7476 0.7523 0.7371 0.7432 0.7254 0.0067 0.0026 0.0075 0.0081 0.0077 0.45 Equity ratio 1.5478 2.4766 0.2625 0.2567 0.2755 0.9993 0.9972 0.8975 0.7598 0.9821 0.76 Debt to equity ratio 3.001 3.037 2.808 2.89 2.65 0.0067 0.0027 0.0023 0.0042 0.0029 1.5 Long term debt equity ratio 1.4653 1.5676 1.31115 1.6810 1.7132 0 0 0 0 0 1 Coverage ratio 6 8 10 9 4 9 3 9 12 15 10 Asset turnover 0.6573 0.6687 0.6897 0.5509 0.6735 0.4094 0.0141 0.5498 0.4256 0.5132 0.5 Adequacy ratio 0.34 0.41 0.57 0.64 0.71 0.87 0.91 0.82 0.87 0.93 0.67 Efficiency ratio 67% 57% 54% 75% 69% 71% 67% 74% 73% 77% 69% Capitalization ratio 6:3 5:4 8:5 6:7 8:4 7:3 5:3 8:7 3:2 5:4 6:4

Ratio analysis

Ratio analysis is an important tool of financial statements analysis ratio is usually indicated as a quotient of two mathematical expressions. Ratios may be expressed in a number of ways (a) percentages (b) fractions and as comparison between numbers. In financial analysis, the relationship two figures may be expressed as a percentage or as a quotient. Ratios assist in analysis and interpretation of results of a firm so that the managers and shareholders can determine the financial position of the company or whether they were a return on a certain undertaking/investment. They are used to test the solvency and profitability of an entity by examining its financial statements. Ratios are calculated from financial statements and are crucial in making strategic decisions for the management since they provide meaningful information pertaining liquidity, profitability and efficiency of the company. They enable the management to draw conclusions in respect of financial strength, position or weakness and soundness of the company.

Capital structure analysis ratios

Capital structure/gearing ratios measure the contribution of financing by owners compared with the financing provided by the firm’s creditor. These include preference shareholders, debenture holders and other long term creditors. These ratios measure the ability of a firm to pay all of its long term debts.

• Debt ratio-indicates to which extent the assets of the firm have been financed using borrowed funds. It is calculated by: Total liabilities/total assets. The higher the ratio the greater the risk related with the company’s business. Virgin Blue ratio is below 0.5 which implies that most of its assets are financed through equity while Qantas ratio is greater than 0.5 indicating the high leverage of the firm and also most assets are financed through debt.
• Debt-equity ratio is a ratio shows the relationship between the owners fund and borrowed funds. The larger the larger of fund provided by owners, the less risks is assumed by creditors. It is expressed as: total debt/total owners equity. This ratio is significant in the sense that it indicates the extent of fixed interest funds being used in business. A low debt-equity ratio implies the use of more equity than debt which means the business is running on low gear and is more likely to earn fewer profits as opposed to a situation where debt is more than equity in which case the firm is likely to get a higher return on equity after paying interest. The ideal debt ratio is 1:1.A debt-equity ratio of 0.66 indicates that the external debt is 0.66% of shareholders funds. Qantas has a proportion of external debt to owners equity and is therefore highly solvent than Virgin Blue.
• Assets turnover ratio is a ratio that’s measures the performance and activity of the business organization in terms of profit making. It is computed as: Sales/total assets. Qantas has a higher ratio which means there is intensive utilization of fixed assets as opposed to Virgin where they experience an under-utilization of assets.
• Time interest earned is a ratio that measures how well the company’s earnings can cover the interest payment on its debt. It is computed as follows: EBIT/interest charges. EBIT means earnings before interest and taxes. It shows the financial strength of the company. Virgin Blue has a high interest ratio and therefore the lender is more assured of regular interest income while Qantas has a low coverage interest ratio and the management would have difficulties raising funds from debt.
• Capitalization ratio is used to analyze the leverage of the company and it is a ratio that defines the relationship between long term financing such as debentures, preference and equity share capital. It is a proportion between fixed interest bearing funds including debentures, preference share capital and a total of equity share capital+reserves+surpluses.It is computed as follows :Equity share capital/fixed interest bearing funds. Qantas Airline has an average of 6:7(high gear) while Virgin Blue has an average of 8:5 which is low gear. This ratio is significant to the management and prospective investors as it reveals the company capitalization.
• Equity ratio shows the relationship between shareholders funds to total assets and indicates the solvency position of the business. Both companies have an average ratio which means that the companies are on a sound capital structure.

References

Brigham, Joel, F. (2009).Fundamentals of Financial Management.Cincinnati: New York, Dryden press.

Williams, Susan, F.H. (2008).Financial and Management Accounting. New York: NY, Mc Graw Hill Irwin.

Westan, J. (1990).Essentials of Managerial Finance.Hindsdale: NY, Dryden Press.