Many of the research works have been conducted, over the period to evaluate the financial position of the company with the help of the various ratios or by applying the Multiple Discriminate Analysis to predict the corporate failure. L.C Gupta (1999) attempted a refinement of Beaver’s method with objective of predicting the business failure. Whereas Mansur. Bagchi S.K (2004) analysed about practical implication of accounting ratios in risk evaluation and concluded that accounting ratios are still dominant factors in the matter of credit risk evaluation.

How to measure Financial Performance?

“There’s no one tool that can measure financial performance or stability of a company or business, there’s a handful of them that can aggregately measures the reliability of the business in terms of profitability performance how well the business has maximize the use of their assets and how well they have managed risk”. These measures are what we called “financial ratios”. A mere glance on a company’s balance sheet won’t tell us anything substantial whether or not the company has a robust financial structure. Same holds true with income statement and the other financial statements. They all become meaningful once we venture out in analyzing and interpreting the data otherwise, it is like gazing on a bunch of trivial numbers. For example, if you compare the financial statements to a façade of a building, you won’t be able to tell the building strength, even how attractive the façade could be, we need to look beyond it further for us to understand the quality of the materials, the mixture, the curing process, the quality of work, so on and so forth to fully gain understanding of what is buried behind the façade. Just like the financial statements, even how attractive the numbers might tell, even how large the figures could be but unless we embark to look further on what these numbers truly indicate, so that we can gain concrete and reasonable comprehension on the real financial condition of the company, we can’t really never tell. It is where financial ratio analysis comes in, in an attempt to give more meat to these numbers and provide a clearer picture on a company’s performance and financial condition. Although financial ratio analysis is not definitive but it is a well-tested tool that can uncover facts and trends to gauge a company’s profitability and risk and can serve as an early warning device for anybody with interest on the business for potential troubles that could include bankruptcy.

Financial Performance characteristics and factors

Present financial literature has explored firm market performance as related to firm-wise financial characteristics from various perspectives. These financial characteristics or factors differ across firms and result from policies regarding operating, investing, financing, and dividend distribution. It is necessary to have an overall review of various financial characteristics discussed in previous studies. Liquidity

Liquidity reveals a company’s ability to meet its short-term obligations and quickness in converting an asset into cash at its fair market value (Scott et al. 1999). Good liquidity management can improve operating results and enhance company performance, whereas poor liquidity management can lead to weak operating profits and hurt company performance in the capital market (Moyer, McGuigan and Kretlow 2001). For a company, insufficient cash may lead to stack out or defaulting on payments, whereas too much money at hand could cut into profitability (Schmidgall, 2006). Therefore, the objective of liquidity management is to find an optimal balance between liquid and illiquid assets to minimize operating costs and hence improve company performance. Some empirical studies supported a positive relationship between liquidity and company performance (Baskin, 1987; Chathoth & Olsen, 2007; Opler et al. 1999); others revealed a negative correlation (Shin & Soenen, 1998).

Financial Leverage Ratios

Financial leverage measures a company’s capital structure (debt versus equity) and reflects a firm’s ability to meet its long-term obligations exposed to financial risk. According to Moyer, McGuigan, and Kretlow (2001), the optimal capital structure theory holds that an inverted U-shape relationship exists between debt usage and company value as reflected in the capital market. The optimal debt level is reached when the costs of debt just offset the benefits of debt. Grossman and Hart (1986), Harris and Raviv (1990), and Zantout (1997) empirically documented a positive association between financial leverage and company performance, whereas Capon, Farley, and Hoenig (1990) and John (1993) showed a negative impact of financial leverage on company performance.Empirical studies have produced mixed findings. In the industry, a number of studies have been conducted by different companies.

Activity

Activity measures management’s efficiency in using company assets to create sales over a certain period of time. Activity reveals how rapidly noncash assets flow through a company and how quickly these assets generate revenue (Moyer et al, 2001). A positive relationship between assets, efficiency, and company performance has been proposed and was empirically supported (Kiymaz, 2006; Roenfeldt & Cooley, 1978). An increase in asset efficiency will lead to higher company value and vice versa.

Growth

According to Reilly and Brown (2006), revenue growth affects company value. High-growth potential often helps push up stock price. Companies with growth capacity might generate increased market share and synergy effects, thereby leading to favourable performance. On the other hand, fast growing companies may be confronted with increased competition and are more sensitive and subjective to economic fluctuations (Idol, 1978; Logue & Merville, 1972). Also, management’s pursuance of growth may be at the expense of the owner’s wealth (Hill & Jones, 1995), leading to a negative relationship between growth and company value. Both positive (Capon et al. 1990; Roenfeldt & Cooley, 1978) and negative (Fuller & Jensen, 2002; Ramezani et al. 2002) relationships were shown by empirical studies, demonstrative of inconclusive findings. In the industry, Chathoth and Olsen (2007) empirically showed that growth did not significantly add firm value or improve company performance during 1995-2000 when general economy was favourable.

Profitability

Higher than expected earnings per share (EPS) is likely to boost investors’ confidence and propel a firm’s stock price (Reilly & Brown, 2006). Therefore, the bottom-line profitability of a company should be positively correlated with company market performance in theory. A direct positive relationship between profitability and company performance was reported by many studies (Hoskisson et al. 1993; Jacobson, 1987; Varaiya & Kerin, 1987).

Size

Large companies tend to possess more resources and better chances when utilizing the capital market (Gupta, 1969; Baum, 1996). In addition, companies may attain better performance from an increase in size due to more reasonable economies of scale, more promotional opportunities, improved efficiency in assets, capital, technology management, and other operational synergies. Conversely, increased size may aggravate corporate red tape and result in a dysfunction of managing the personnel and other resources. Fama and French (1993) argue that size may negatively affect company performance. Some studies such as Berman, Wicks, Kotha, and Jones (1999), Hoskisson (1987), and Keating (1997) observed a positive impact of size on company performance, while others (e.g. O’Neill, Saunders, & MaCarthy, 1989; Westphal, 1998; Wu, 2006; and Zajac, 1990) revealed that there is mixed or no significant side effects.

Dividend Policy

Dividend policy determines if and how to distribute company’s earnings. According to the bird-in-the-hand hypothesis (Gordon & Shapiro, 1956; Gordon, 1963), firms may distribute dividends to reduce investor uncertainty, thereby increasing company value (Moyer et al, 2001). Furthermore, the agency theory suggests that dividend payouts may lower agency costs because the payment of dividends can reduce the available amounts of retained earnings for management’s discretionary use (Moyer et al. 2001). Thus, a positive relationship between dividend payouts and company performance is expected based on both agency theory and the bird-in-the- hand hypothesis. On the other hand, companies that do not distribute cash dividends may signal good growth potential, which may lead to better future returns (Moyer et al. 2001). This growth signal hypothesis suggests a negative relationship between dividend payouts and company performance. Mixed empirical evidence was found by a number of studies. Naranjo, Nimalendran, and Ryngaert (1998) reported a positive relationship. Conversely, Mooradian and Yang (2001) found a negative impact of dividend payout on company performance. Alternatively, some studies indicated that dividend policy may have no significant impact on stock price at all (Benartzi et al. 1997; Christie, 1990).

Financial Ratio Analysis

The use of financial ratios for business analysis is common, and hence, almost all the textbooks introduce similar sets of ratios to analyze business performance – Accounting for the Hospitality Industry by Moncarz and Portocarrero (2004), Financial Management for the Hospitality Industry by Andrew and Schmidgall (1993), Hospitality Financial Management by Chatfield and Dalbor (2005), Hospitality Industry Financial Accounting and Hospitality Industry Managerial Accounting by Schmidgall and Damitio (2006) to name only a few. From this point of view, ratio analysis techniques can be considered a business analysis concept as “an established point of view” (Kuhn, 1996, p. 39). However, despite the wide coverage of financial ratios in textbooks, academic literature that introduces them as tools for operations analysis is not so common (Thomas and Evanson, 1987). Although several researchers have addressed financial ratios as performance indicators (Ryu and Jang, 2004), or financial trend indicators for different sectors of the industry (Kim and Ayoun, 2005), it is not clear how effectively practitioners capitalize on the findings or arguments presented in academic journals because of their lack of interest in academic papers (Cobanoglu et al. 2002) or their propensity of preferring simpler techniques even at the cost of accuracy (Sheel, 2004). Considering these facts, encouraging industry operators to apply the techniques of ratio analysis to assess their performance requires a simple framework that compresses a large amount of data into a small set of performance indicators. These performance indicators must include intangible, non-financial elements that are often critically important to operators (Mongiello and Harris, 2006). Current literature has many suggestions regarding how accounting or financial management knowledge should be practiced or taught. Few authors have addressed the role of operators from the perspective of capital investment and required return. Simply, operators’ roles have been taken for granted at the receiving end of the spectrum in the corporate management information systems leaving them with no sense of autonomy (Turnbull, 2001).

A financial ratio is a relationship of two values of financial statements. Ratios basically are mathematical expressions, which are calculated to derive certain conclusion. The ratio are expressed as number of times, proportion or percentage. There are numbers of ratios, but which to consider for a particular type of analysis is left to the personal judgement of the analysts. As a matter of fact, all the ratios are for different purpose and have different objectives.

The most extensively discussed cross-sectional tool is financial ratio analysis. Many alternative categories of financial ratios and numerous individual ratios have been proposed in the literature. The following four categories and ratios within each category are meant to be illustrative rather than exhaustive:

Liquidity ratios.

Leverage/ capital structure ratios.

Profitability ratios.

Turnover ratios.

Limitations of the financial statements

The discussion of the nature of financial statements develops, as a corollary, an appreciation of their limitations. Four important facts with respect to the limitations of the statements are:

Precision of the financial data is impossible, because the statements deal with matters that cannot be sated precisely. The data are produced by conventional procedures developed by the accounting profession through many years of experience, implemented by various postulates or assumptions, and applied by judgment.

The statements do not show the financial condition of a business, since there are usually many factors which are not part of the financial statement data that have an important bearing on financial condition. Rather, the statements show the pension of the financial accounting for a business.

The assets shown in balance sheet are largely unexpired or unamortized costs the balance sheet does not usually show the market values of assets. From this it follows that the balance sheet does not show what a business is worth, that is, what might be obtained for it if it were sold?

The net income shown in the income statement is not absolute but relative, dependent as it is in the particular conventional procedures used in its accounting by the enterprise for which the statement is compiled, these procedures having been selected from among various alternatives.

(john n. Myer. “financial statement analysis”, 4th edition, Englewood cliffs, new jersey, prentice-hall,inc.p-24)

Limitations of Financial Ratios

Ratios are based on financial statements, so contain almost all of the deficiencies of those account.

Some ratios are open for manipulation and need to be interpreted with care. E.g. stock levels may be kept artificially low at year-end, creating an impression of high efficiency in this area.

Inter-firm comparisons are faced with the problem that different organisations might use rather different policies. E.g. depreciation method etc.

Detailed knowledge of a company’s markets in seldom obtainable from the publish accounts, but is extremely important for assessing future profitability.

Ratios are useful when comparing similar organisations operating under similar conditions. Comparisons with different types of organisations can be misleading.

There is a real danger that ratio analysis can lead to conclusions, which are over simplified. E.g. high current ratio.

Why use ratios?

It has been said that you 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 our references so we can understand how well we are performing financially. Ratios also extend our traditional way of measuring financial performance; i.e. relying on financial statements. By applying ratios to a set of financial statements, we can better understand financial performance.

Liquidity ratios

Liquidity Ratios help us understand if we can meet our obligations over the short-run. Higher liquidity levels indicate that we can easily meet our current obligations. We can use several types of ratios to monitor liquidity.

Current ratio

This ratio has a very long history in liquidity analysis. Foulke (1968, p-181)

Current Ratio is simply current assets divided by current liabilities. Current assets include cash, accounts receivable, marketable securities, inventories, and prepaid items. Current liabilities include accounts payable, notes payable, salaries payable, taxes payable, current maturities of long-term obligations and other current accruals. A low current ratio would imply possible insolvency problems. A very high current ratio might imply that management is not investing idle assets productively.

Acid Test or Quick ratio

Since certain current assets (such as inventories) may be difficult to convert into cash, we may want to modify the Current Ratio. Also, if we use the LIFO (Last In, First Out) Method for inventory accounting, our current ratio will be understated. Therefore, we will remove certain current assets from our previous calculation. This new ratio is called the Acid Test or Quick Ratio; i.e. assets that are quickly converted into cash will be compared to current liabilities. The Acid Test Ratio measures our ability to meet current obligations based on the most liquid assets. Liquid assets include cash, marketable securities, and accounts receivable. The Acid Test Ratio is calculated by dividing the sum of our liquid assets by current liabilities.

Both the current and quick ratios have been criticized on the basis that they do not incorporate information about the timing and magnitude of future cash inflows and outflows. Walter (1957) and Lemke (1970).

Defensive Interval Measure

Defensive Interval is the sum of liquid assets compared to our expected daily cash outflows. The Defensive Interval is calculated as follows:

(Cash + Marketable Securities + Receivables) / Daily Operating Cash Outflow

Davidson et al. (1964) describe the components of the measure as follows:

Defensive assets include cash, short-term marketable securities and accounts receivables. Inventories are not included in the total, nor are current liabilities deducted from the total. The denominator includes all projected operating costs requiring the use of defensive assets. Ideally, this would be based on the cash budget for the next year or shorter period. Since this information unlikely to be available to external analyst, the total of operating expenses on the income statement for the prior period will usually serve as a basis for calculating the projected expenditures. Two adjustments must be made to the total expense figure on that statement:

Depreciation, deferred taxes and other expenses that do not utilize defensive assets must be subtracted.

Adjustment should be made for known changes in planned operations

Profitability Ratios

Profitability Ratios measure the level of earnings in comparison to a base, such as assets, sales, or capital. Profitability ratios are: Return on Equity, Profit Margin, Operating Income to Sales and Return on Assets.

Return on Equity

The relationship of earnings to equity or Return on Equity is of prime importance since management must provide a return for the money invested by shareholders. Return on Equity is a measure of how well management has used the capital invested by shareholders. Return on Equity tells us the percent returned for each dollar (or other monetary unit) invested by shareholders. Return on Equity is calculated by dividing Net Income by Average Shareholders’ Equity (including Retained Earnings).

Return on Equity has three ratio components. The three ratios that make up Return on Equity are:

Profit Margin = Net Income / Sales

Asset Turnover = Sales / Assets

Financial Leverage = Assets / Equity

Profit Margin measures the percent of profits you generate for each dollar of sales. Profit Margin reflects your ability to control costs and make a return on your sales. Profit Margin is calculated by dividing Net Income by Sales. Management is interested in having high profit margins.

Asset Turnover measures the percent of sales you are able to generate from your assets. Asset Turnover reflects the level of capital we have tied-up in assets and how much sales we can squeeze out of our assets. Asset Turnover is calculated by dividing Sales by Average Assets. A high asset turnover rate implies that we can generate strong sales from a relatively low level of capital. Low turnover would imply a very capital-intensive organization.

Financial Leverage is the third and final component of Return on Equity. Financial Leverage is a measure of how much we use equity and debt to finance our assets. As debt increases, we financial leverage increases. Generally, management tends to prefer equity financing over debt since it carries less risk. The Financial Leverage Ratio is calculated by dividing Assets by Shareholder Equity.

Return on Asset

The concept of return on asset (ROA) carries more importance than the profit from their operations (ROS). The dual dimensions of ROA, often called Du Pont ratio (Chatfield and Dalbor, 2005), as the product of ROS and the asset turnover ratio, have been introduced for a long time to address the two different value drivers of business operations (Copeland et al. 1996, 2000; Moyer et al. 1995; Palepu et al. 1996, p. 4; Schmidgall, 2006). Compared with the wide use of ROS, the asset turnover ratio does not seem to attract as much industry attention. Appropriate use of this ratio (asset turnover) in conjunction with ROS can address hidden phases of management decisions and how their effects may be based on intangible elements that are true value drivers to operators (Mongiello and Harris, 2006).

Return on Assets measures the net income returned on each dollar of assets. This ratio measures overall profitability from our investment in assets. Higher rates of return are desirable. Return on Assets is calculated as follows:

Net Income / Average Total Assets

Return on Assets is often modified to ensure accurate measurement of returns. For example, we may want to deduct out preferred dividends from Net Income or maybe we should include operating assets only and exclude intangibles, investments, and other assets not managed for an overall rate of return.

Leverage Ratios

Leverage Ratios measure the use of debt and equity for financing of assets. We previously looked at the Financial Leverage Ratio as part of Return on Equity. Three other leverage ratios that we can use are Debt to Equity, Debt Ratio, and Times Interest Earned.

Debt to equity

The debt-equity ratio shows the proportion of debt funds to equity. The numerator includes both secured and unsecured loans and the denominator includes ordinary and preference share capital and reserves and surplus. A high debt-equity ratio signifies a high leverage (Khan and Jain, 2004). Traditionally, a ratio of 2:1 was considered acceptable but the situation is different now. Nowadays, there is a burgeoning concept of zero debt companies, which are doing very well even with nil leverage.

Debt to Equity is the ratio of Total Debt to Total Equity. It compares the funds provided by creditors to the funds provided by shareholders. As more debt is used, the Debt to Equity Ratio will increase. Since we incur more fixed interest obligations with debt, risk increases. On the other hand, the use of debt can help improve earnings since we get to deduct interest expense on the tax return. So we want to balance the use of debt and equity such that we maximize our profits, but at the same time manage our risk. The Debt to Equity Ratio is calculated as follows:

Total Liabilities / Shareholders Equity

Debt Ratio

The Debt Ratio measures the level of debt in relation to our investment in assets. The Debt Ratio tells us the percent of funds provided by creditors and to what extent our assets protect us from creditors. A low Debt Ratio would indicate that we have sufficient assets to cover our debt load. Creditors and management favor a low Debt Ratio. The Debt Ratio is calculated as follows:

Total Liabilities / Total Assets

Times Interest Earned

Times Interest Earned is the number of times our earnings (before interest and taxes) covers our interest expense. It represents our margin of safety in making fixed interest payments. A high ratio is desirable from both creditors and management. Times Interest Earned is calculated as follows:

Earnings Before Interest and Taxes / Interest Expense

Asset Management ratios

Asset management ratios measure the ability of assets to generate revenues or earnings. They also compliment our liquidity ratios. We looked at one asset management ratio already; namely Total Asset Turnover when we analyzed Return on Equity. We will now look at five more asset management ratios: Accounts Receivable Turnover, Days in Receivables, Inventory Turnover, Days in Inventory, and Capital Turnover.

Accounts Receivable Turnover

Accounts Receivable Turnover measures the number of times we were able to convert our receivables over into cash. Higher turnover ratios are desirable. Accounts Receivable Turnover is calculated as follows:

Net Sales / Average Accounts Receivable

Days in Accounts Receivable

The Number of Days in Accounts Receivable is the average length of time required to collect our receivables. A low number of days is desirable. Days in Accounts Receivable is calculated as follows:

365 or 360 or 300 / Accounts Receivable Turnover

Inventory Turnover

Inventory Turnover is similar to accounts receivable turnover. We are measuring how many times we turned our inventory over during the year. Higher turnover rates are desirable. A high turnover rate implies that management does not hold onto excess inventories and our inventories are highly marketable. Inventory Turnover is calculated as follows:

Cost of Sales / Average Inventory

Days in Inventory

Days in Inventory are the average number of days we held our inventory before a sale. A low number of inventory days is desirable. A high number of days imply that management is unable to sell existing inventory stocks. Days in Inventory is calculated as follows:

365 or 360 or 300 / Inventory Turnover

Capital Turnover

One final turnover ratio that we can calculate is Capital Turnover. Capital Turnover measures our ability to turn capital over into sales. Remember, we have two sources of capital: Debt and Equity. Capital Turnover is calculated as follows:

Net Sales / Interest Bearing Debt + Shareholders Equity

Market Value Ratios

These ratios attempt to measure the economic status of the organization within the marketplace. Investors use these ratios to evaluate and monitor the progress of their investments.

Earnings per share

Growth in earnings is often monitored with Earnings per Share (EPS). The EPS expresses the earnings of a company on a per share basis. A high EPS in comparison to other competing firms is desirable. The EPS is calculated as:

P/E Ratio

The relationship of the price of the stock in relation to EPS is expressed as the Price to Earnings Ratio or P / E Ratio. Investors often refer to the P / E Ratio as a rough indicator of value for a company. A high P / E Ratio would imply that investors are very optimistic (bullish) about the future of the company since the price (which reflects market value) is selling for well above current earnings. A low P / E Ratio would imply that investors view the company’s future as poor and thus, the price the company sells for is relatively low when compared to its earnings. The P / E Ratio is calculated as follows:

Book Value per Share

Book Value per Share expresses the total net assets of a business on a per share basis. This allows us to compare the book values of a business to the stock price and gauge differences in valuations. Net Assets available to shareholders can be calculated as Total Equity less Preferred Equity. Book Value per Share is calculated as follows:

* Calculated as Total Equity less Preferred Equity.

Dividend Yield

The percentage of dividends paid to shareholders in relation to the price of the stock is called the Dividend Yield. For investors interested in a source of income, the dividend yield is important since it gives the investor an indication of how much dividends are paid by the company. Dividend Yield is calculated as follows:

Dividends per Share / Price of Stock

Comparing Financial Statements

One final way of evaluating financial performance is to simply compare financial statements from period to period and to compare financial statements with other companies. This can be facilitated by vertical and horizontal analysis.

Vertical Analysis

Vertical analysis compares line items on a financial statement over an extended period of time. This helps us spot trends and restate financial statements to a common size for quick analysis. For the Balance Sheet, we will use total assets as our base (100%) and for the Income Statement, we will use Sales as our base (100%). We will compare different line items on the financial statements to these bases and express the line items as a percentage of the base.

Horizontal Analysis

Horizontal analysis looks at the percentage change in a line item from one period to the next. This helps us identify trends from the financial statements. Once we spot a trend, we can dig deeper and investigate why the change occurred. The percentage change is calculated as:

(Dollar Amount in Year 2 — Dollar Amount in Year 1) / Dollar Amount in Year 1