Financial Analysis Techniques: Financial Indicators

Financial Analysis Techniques: Financial Indicators

Financial analysis is a technique for evaluating the operational behavior of a company, diagnosing the current situation, and predicting future events and, consequently, is oriented towards obtaining previously defined objectives. Therefore, the first step in a process of this nature is to define the objectives to then formulate the questions and criteria that will be satisfied with the results of the analysis —which is the third step— through various techniques.

Financial analysis tools can be limited to the following: a) comparative analysis, b) trend analysis; c) proportional financial statements; d) financial indicators, and e) specialized analyses, among which stand out the statement of changes in financial position and the statement of cash flows.

Financial indicators

Financial indicators group a series of formulations and relationships that allow standardizing and adequately interpreting the operating behavior of a company, according to different circumstances. Thus, it is possible to analyze short-term liquidity, its capital structure and solvency, the efficiency of the activity, and the profitability produced with the available resources.

Consequently, the indicators are classified as follows:

liquidity ratios

  1. current reason
  2. Acid test
  3. working capital
  4. defensive basic interval

Capital structure ratios

  1. total leverage
  2. debt level
  3. Number of times interest is earned

Reasons for activity

  1. Purse rotation
  2. Portfolio collection period
  3. inventory turnover
  4. Inventory days
  5. supplier rotation
  6. Purchase days in accounts payable
  7. Net cycle to market
  8. asset turnover

profitability ratios

  1. return on investment
  2. profit margin
  3. return on equity

Once the selected indicators have been calculated to answer the questions raised, they are interpreted, which is perhaps the most delicate part of a financial analysis process, because it no longer involves a quantitative part, but a great deal of subjectivity and inherent limitations. to the handling of information that could, among other things, have been manipulated or simply mispresented. In addition, several external factors affect the results obtained, mainly due to the effect of inflation.

For this reason, all the operations carried out by a company, in a given period, must be subjected to a process of adjustments for inflation, with the purpose that the figures thrown, by said operations, are expressed in constant pesos or of the same purchasing power. In addition, for comparative purposes, the financial statements must be restated from one year to the next, after having been adjusted for inflation.

This situation means that certain financial ratios cannot be calculated with the figures issued in the financial statements, but must be subjected to an additional purification or “correction”, which advocates that the interpretation of such results is not distorted and leads to erroneous judgments. and to make wrong decisions.

Classification of financial reasons

Financial ratios have been classified, for better interpretation and analysis, in multiple ways. Some authors prefer to give greater importance to the profitability of the company and begin their study with the components that make up this variable, continuing, for example, with the explanation of the solvency, liquidity, and efficiency indicators. Other texts raise solvency first and then profitability and stability, defining the latter in the same category as efficiency. In the same way, hundreds of ratios or indices can be calculated based on the financial statements of an economic entity, but not all of them are important when diagnosing a situation or evaluating a result.

For these reasons, in this text, the various indicators have been classified into four groups and only those most commonly used and that have real importance for the intended purposes of the work and its users will be explained. These groups are:

  1. Liquidity ratios, which assess the company’s ability to meet its short-term obligations. It implies, therefore, the ability to convert assets into cash.
  2. Capital structure and solvency ratios, which measure the degree to which the company has been financed by debt.
  3. Activity ratios, which establish the effectiveness with which company resources are being used.
  4. Profitability ratios, which measure the efficiency of administration through the returns generated on sales and investment.

In turn, each of these groups incorporates a series of reasons or indices that will be studied independently. However, before entering into the proposed study of financial indicators, attention should be drawn to a fact that, strangely, goes unnoticed in most of the texts on financial statement analysis published for students in our country. This fact refers to the inflation that is recurrent in our environment and that, in addition, its effect must be calculated and accounted for. These circumstances (inflation and accounting records) lead to a new way of interpreting the results obtained,

Income from exposure to inflation

Fiscal and accounting standards define profit or loss from exposure to inflation as the credit or debit balance recorded in the monetary correction account, respectively. In turn, the monetary correction account is made up of the inflation adjustments made to the non-monetary balance sheet accounts and all the income statement accounts, as summarized in the following table:

Investments in shares and contributions Credit
Property, plant, and equipment (cost) Credit
Accumulated depreciation and depletion Debit
Intangible assets (cost) Credit
Deferred assets (cost) Credit
Accumulated amortization Debit
Heritage Debit

According to the definition given, regarding the adjustments that affect the monetary correction account, it can be seen that said account is made up of a) adjustments to balance sheet accounts and b) adjustments to result accounts. The first, whose net balance will hereinafter be generically referred to as “profit from asset holdings”, increase or decrease profit because they are recorded in cross-balance sheet and income statements; On the other hand, the latter do not alter the accounting profit, since their registration affects, as a debit and as a credit —simultaneous— only income statement accounts. Likewise, a part of the inflation adjustments to assets is transferred to the income statement, either as a higher value of the cost of goods sold (adjustment to inventories), as a higher depreciation expense, depletion, or amortization (fixed, intangible and deferred assets) or as a lower profit on the sale (investments in shares and contributions). Therefore, the traditional accounting profit is affected by three factors, diametrically different in their effect on the final profit or loss:

1. Adjustment to income accounts: they do not alter the final utility, because they are recorded as a higher value of the respective income or expense against the monetary correction account. However, the inflation adjustments to the two basic components of the income statement, income, and expenses, have completely different connotations for purposes of calculating financial indicators that indicate or diagnose the situation of an economic entity, even if their adjustment is justified in the sense that they express in homogeneous terms (pesos of the last day of the period under study) all the operations carried out during the year.

Under these circumstances, the adjustment for inflation to general costs and expenses is defined as the highest value that the company would have to pay to incur the same costs and expenses but on the last day of the year or period, when the prices of said items are have increased as a result of inflation. In other words, if the company wanted to continue operating at least in the same dimensions and magnitudes as the previous year, it should have sufficient resources to meet its costs and expenses, but at the new prices. In this sense, the adjustment for inflation to costs and expenses must be subtracted from profits because it represents the largest disbursement that will have to be made, and, therefore, the money to attend to this greater outflow of money must come from profits. if you do not want to deteriorate the assets of the company. Therefore, for the analysis by reasons, the costs and expenses must be taken adjusted for inflation.

On the other hand, the adjustment for inflation to income is only useful for purposes of comparison between one exercise and another, but not for the estimation of financial indicators, because said adjustment, contrary to what was explained in the case of costs and expenses In general, economically it does not mean, for any reason, that because inflation has occurred, income will grow automatically.

2. Adjustment to balance accounts: One hundred percent increase or decrease the final profits registered by an economic entity, because its counterpart always affects the monetary correction account, which belongs to the income statement. However, as can be easily seen, this kind of profit has not been realized and does not come from the company’s operations, which is why it could not be incorporated into the indicators that use reported profits or losses as a parameter and which include, by legal obligation, this type of utilities. On the other hand, with some reservations, the adjustments that directly affect the balance sheet accounts, since they are the counterpart of the monetary correction account, are taken into account in the design of financial indicators.

3. Adjustments to balance sheet accounts that are transferred to the income statement: part of the inflation adjustments to the balance sheet accounts —at one time or another— must be transferred as a higher value of cost or general expenses. A typical case of this situation is observed in inventories, which are restated for inflation, but at the time of being consumed or sold, they must affect profits not by the historical cost of acquisition but by their adjusted cost up to the time of being consumed. or sold. In the same way, but in longer terms, it occurs with depreciation, depletion, and amortization, which must be calculated on the acquisition cost, but duly adjusted for inflation, which produces that the expense for these concepts is greater than what is estimated. would be recorded if there were no obligations to make adjustments for inflation.

In summary, it is neither prudent nor technical to take the figures reflected in the financial statements —neither at historical values nor with figures adjusted for inflation— without first understanding in some depth the philosophy of the comprehensive system of adjustments for inflation and the implications that entail their accounting procedures, to correct some of the bases that serve as a parameter for the calculation of financial indicators. This means that, in some cases, the components of a ratio or index must be taken based on their original or historical acquisition values, in others according to the figures adjusted for inflation, and in others, the balances must be corrected to eliminate adjustments. partial or total due to inflation,

Interpretation of financial ratios

For the reasons stated, financial indicators must be interpreted with caution since the factors that affect one of its components —numerator or denominator— can also directly and proportionally affect the other, distorting the financial reality of the entity. For example, classifying a short-term obligation within long-term liabilities can misleadingly improve the current ratio.

Due to this circumstance, when studying the change that occurred in an indicator, it is desirable to analyze the change presented, both in the numerator and in the denominator, to better understand the variation detected in the indicator.

Due to the above considerations, careful analysis of the notes to the financial statements is recommended, since it is there where the accounting policies and valuation criteria used are revealed.

Likewise, the results of the analysis by financial indicators must be compared with those presented by similar companies or, better, of the same activity, to grant validity to the conclusions obtained. Because it can be reflected, for example, a 25 percent increase in sales that would seem to be very good —looked at individually— but that, nevertheless, if other companies in the sector have increased their sales by 40 percent, perhaps The 25 percent increase is not a favorable trend, when taken together and comparatively.

Liquidity ratios

Liquidity analysis allows for estimating the company’s ability to meet its obligations in the short term. As a general rule, short-term obligations are recorded on the balance sheet, within the group called “Current liabilities” and include, among other items, obligations with suppliers and workers, bank loans with a maturity of less than one year, taxes payable, dividends and shares payable to shareholders and partners and unpaid caused expenses.

Such liabilities must be covered with current assets since their nature makes them potentially liquid in the short term. For this reason, fundamentally the liquidity analysis is based on current assets and liabilities since it seeks to identify the ease or difficulty of a company to pay its current liabilities with the product of converting its assets into cash, also current.

For the explanation of each one of the financial reasons, the figures of the financial statements incorporated in the appendix of this text will be used as a model.

Current reason

This indicator measures the current availability of the company to meet existing obligations on the date of issuance of the financial statements being analyzed. Therefore, by itself, it does not reflect the ability to meet future obligations, since this also depends on the quality and nature of current assets and liabilities, as well as their turnover rate.

Current Assets / Current Liabilities

Historical Tight
1,058,535 1,639,870 1,058,703 1,639,969
667,445 1,586,299 667,445 1,586,298
1.59 1.03 1.59 1.03

In this case, updating inventories (an important component of current assets) at current prices is not significantly influencing the behavior of the indicator, a fact that may indicate a good inventory turnover. If the inventories were very old, then the indicator would tend to be higher after applying the comprehensive adjustment system for inflation, although this does not necessarily indicate a better possibility of meeting short-term obligations, since there may be obsolete inventories whose realization in the market is not easy to carry out.

The interpretation of this financial ratio must be carried out in conjunction with other behavioral results, such as the turnover and acid test rates, although everything seems to indicate that the estimated ratios based on historical values ​​can indicate more efficiently the situation of the companies in the short term. the term, against its obligations.

See also  Definition of the main Financial ratios

The current ratio indicator presents some kind of limitations in the interpretation of its results, the main one being the fact that this ratio is measured statically, at a given moment in time and, consequently, it cannot be ensured that In the future, the available resources continue to be so. In addition, when breaking down the various factors of current reason, serious arguments are found about the reasonableness of its function. For example, cash balances or securities deposited in temporary investments represent only a margin of safety against eventual atypical business situations and, for no reason, reserves for the payment of current operations of the company; since assuming the opposite would be like discarding the principle of continuity and thinking that the company is going to be liquidated shortly.

In the same way, accounts receivable and inventory are permanent movement accounts and because of this, it is not at all safe to assume that a high balance should remain so, especially when it is required to meet current obligations. The two variables are closely interrelated with concepts such as sales level or profit margin these concepts are the true parameters in determining future cash inflows.

The foregoing can be summarized by stating that a company’s liquidity depends more on expected future cash flows than on balances, of the same nature, recorded in accounting at the time of analysis. In addition, the efficiency in the rotation of accounts receivable and inventories aims to achieve maximum profitability in the use of assets and not necessarily obtain greater liquidity.

Another limitation of the current ratio is that its result can be easily manipulated to obtain figures that are required for some special purpose. For example, on the last day of the year, an important liability could be canceled and retaken on the first day of the following year, with which the ratio improves by simultaneously decreasing both the asset (from whose funds the resources are taken) and the current liability. Significant items that have to do with inventories in transit can also be premeditated and unaccounted for; By not recording assets or liabilities, the current ratio improves. Likewise, the decision to make new purchases could be postponed, given the proximity of accounting closing, managing to reduce both current assets and liabilities, but increasing the indicator.

There are some standards on this indicator that, sometimes, are automatically taken as measurement parameters, when in reality each particular case must be evaluated in its dimensions. This is how it is stated that a 2:1 ratio, that is, having current assets that double short-term obligations, is ideal; however, there may be situations in which there are minimum levels of inventories and optimal turnover of accounts receivable, with which there will be sufficient liquidity to meet current liabilities, even if the indicator does not seem to be the best.

On the other hand, it could be thought that the higher the current ratio, the better the financial management of resources. But, if this case is looked at objectively, a very high indicator, although it is stimulating for suppliers and financial entities because it practically ensures the return of debts, it is also a sign of a bad administration of cash and excess in own investment, coming from of partners and shareholders, who will be affected by the rate of return associated with the said investment.

Acid test

By not including the value of the inventories owned by the company, this indicator indicates with greater precision the immediate availabilities for the payment of short-term debts. Consequently, the numerator will be made up of cash (cash and banks) plus temporary investments (Cdt’s and other immediately realizable securities), currently called “cash equivalents”, and “accounts receivable”.

(Current Assets – Inventories) / Current Liabilities

Historical Tight
2.0X1 2.0X2 2.0X1 2.0X2
800,974 1,121,825 801.142 1,121,924
667,445 1,586,299 667,445 1,586,298
1.20 0.71 1.20 0.71

As in the case of the current ratio, the acid test indicator is not affected by inflation because its components are monetary items, expressed in original nominal values, that is, they do not change due to variations in the general level of prices, although they are strongly affected in terms of purchasing power.

In the example, for the year 20X2, there was a noticeable deterioration in the index, possibly due to the acquisition of new liabilities (see comparative balance sheet and trend analysis) whose destination was not working capital but investment in fixed assets. It is worth asking here if the expansion of the physical structure through short-term loans will allow an increase in sales, capable of generating sufficient resources to meet said obligations. Quite possibly, this company will have to restructure its liabilities or sell part of its fixed assets, under the pain of being faced with financial problems.

The same limitations exposed when the current ratio was studied apply to this ratio since it is also a static test that does not take into account the principle of continuity and starts from the assumption that the company will enter into a liquidation process and, consequently, will not generate any kind of operations that generate cash flows, such as new sales of products or services of its activity.

Likewise, eliminating the inventory account from the numerator does not guarantee better liquidity since the quality of the accounts receivable must be taken into account, a concept that will be studied later, and the ease of carrying out the inventory, since sometimes it is easier sell the stock of merchandise or products to recover the portfolio. If the accounts receivable have a slow turnover, it is recommended to eliminate this item for the calculation of the acid test, including in the numerator, therefore, only cash and temporary investments or cash equivalents. When this filtering is carried out, the indicator thus calculated is called the «extreme liquidity ratio».

Working capital

Although this result is not properly an indicator, since it is not expressed as a ratio, it complements the interpretation of the “current ratio” by expressing in pesos what it represents as a relationship.

Current Assets – Current Liabilities

Historical Tight
391,090 53,571 391,258 53,571

Once again here it can be observed that the slight variations that occur between the results, before and after adjustments for inflation, are not relevant, which indicates —as already indicated— an optimal inventory rotation.

This result indicates the excess or deficit of the company, represented in current assets, which would occur after canceling all current liabilities. As can be seen, working capital presents the same limitations found for the current ratio, since it corresponds to the absolute expression of a relative result.

Defensive basic interval

It is a measure of general liquidity, implemented to calculate the number of days during which a company could operate with its current liquid assets, without any kind of income from sales or other sources.

Although it is not a widely used indicator, in times of inflation its result can be extremely useful in certain business circumstances, such as labor negotiations (possibility of strikes or indefinite stoppages) or contracting of general insurance (especially loss of profits).

(Cash + Temporary Investments + Accounts Receivable) / (Cost of Sales + General Expenses) / 365

Historical Tight
786,707 1,121,825 786,875 1,121,924
1,297,311 ÷ 365 2,701,706 ÷ 365 1,326,437 ÷ 365 2,888,398 ÷ 365
221 152 217 142

The result indicates that the company could continue to meet its obligations for 217 days, with the results of 20X1 adjusted for inflation, and for 142 days with those of 20X2, in exchange for the number of days shown for the same years, but without having eliminated the effect. of inflation, which is why this indicator should be taken including adjustments for inflation.

The capital structure of a company can be defined as the sum of funds from own contributions and those acquired through long-term debt; while the financial structure corresponds to all the debts —both current and non-current— added to the patrimony or internal liabilities. The sources of acquisition of funds, together with the class of assets held, determine the greater or lesser degree of solvency and financial stability of the economic entity. The relative magnitude of each of these components is also important in assessing the financial position at a given time.

The solvency indicators reflect the company’s ability to meet the obligations represented in fixed charges for interest and other financial expenses, as a result of its short and long-term contractual obligations, as well as the timely reimbursement of the amount owed. This means that the proportion of debt and the magnitude of the fixed costs derived from it are indicators of the bankruptcy probabilities of a company due to insolvency and the risk assumed by investors, given the variability of expected profits that constitute your performance.

Businesses get into debt for many reasons. The main one is that borrowing can be cheaper than own financing since, as a general rule, investors demand a higher remuneration (otherwise, they would prefer to be creditors and not investors), since within said remuneration must be incorporated the financing cost. In other words, the return paid to creditors is fixed, while it is variable in the case of partners or shareholders. With a simple example, the above statement can be better understood. Suppose a company with total assets equivalent to one million pesos, which can be financed with its resources, through external financing, or with a combination of both sources.

CAPITAL DEBT UAII INTEREST UAI RETURN
1,000,000 0 400,000 0 400,000 40.00%
800,000 200,000 400,000 60,000 340,000 42.50%
600,000 400,000 400,000 120,000 280,000 46.67%
500,000 500,000 400,000 150,000 250,000 50.00%
300,000 700,000 400,000 210,000 190,000 63.33%
100,000 900,000 400,000 270,000 130,000 130.00%

Where it can be seen that to the extent that the debt is greater, the profitability of investors will also be higher about the capital contributed. Due to this circumstance, it is affirmed that the cost of financing through debt is less than the cost of own resources, given its variability in the latter case.

Another reason for indebtedness is the deductibility of interest, which can produce, through the lower tax paid in use of said prerogative, an important generation of internal resources for future own financing of its operations; as long as said lower tax, caused by the use of the deduction from financial expenses, is withheld from net profits, to prevent the resources thus generated from being implicitly distributed to shareholders. For example, if a company finances itself 100 percent with its own resources (company X) and another company does so in equal parts (company Y), one would have:

CAPITAL DEBT UAII
Earnings before interest and taxes 400,000 400,000
Taxes (30% on $500,000) 150,000 0
Profit before taxes 250,000 400,000
Income tax (35%) 87,500 140,000
Net profit 162,500 260,000

The situation that indicates a lower tax of $52,500, the product of applying the tax rate (35 percent) to the amount of interest accrued ($150,000), which means that the state subsidizes —in a certain way— the cost of external financing obtained by the economic entities.

From a strategic planning point of view, the company should not distribute this lower tax ($52,500), but retain it as a voluntary reserve, to be accumulated and, subsequently, used in new investment plans.

However, this advantage has been lost in Colombia with the implementation of the comprehensive system of adjustments for inflation that taxes, precisely, the indebtedness in nominal pesos, that is, it taxes the gain obtained by registering debts that will be paid, in the future, in pesos with less purchasing power.

Capital structure and solvency ratios

To assess the risks explained above and the possibilities of meeting long-term liabilities, there are some financial indicators, such as those studied below:

Total leverage

It measures to what extent the assets of the owners of the company are compromised concerning their creditors. They are also called leverage ratios, since they compare the financing from third parties with the resources provided by the shareholders or owners of the company, to identify who bears the greatest risk.

Liabilities / Equity

DEBT UAII
1,029,660 1916.691 1,029,660 1,916,691
505,826 913,750 576,844 1,008,133
2.04 2.10 1.78 1.90

For this example, the results can be interpreted as follows: for each peso of equity, there are debts of 2.04 and 2.10, for each of the years studied, before adjustments for inflation; and 1.78 and 1.90, after applying the integral system. It is also usually interpreted as a relationship between the two variables that intervene in the design of the indicator; that is, it could be affirmed that, after adjustments for inflation, the owners are 178 and 190 percent committed, respectively.

In nations with low inflation rates, some variants of the previous formulation have been designed to improve and specify the results. One of these variations is the “Liabilities-Capital” ratio, which differs from the one studied previously in that it does not include all the items that makeup equity, but only social capital:

Liabilities / Equity

, in our country, it would have to be modified to add the equity revaluation account, whose philosophy is precise to estimate the loss of purchasing power of the initial capital to know what the number of contributions required would be if you wanted to start a new company with the operational and market characteristics of the entity that is currently operating:

Liabilities / (Capital + Equity Revaluation)

See also  Financial analysis for decision-making through financial indicators

The indicators related to the concept of “leverage” and that, therefore, include the company’s equity in their analysis are, as already defined, analyses of the financial and capital structure and risk measures, because, in situations in which said indicator is high, the higher the interest payments and the disbursements to meet the obligation and also the greater the risks of insolvency, in times of economic slowdown or due to particular problems of the entity.

It should be remembered that a company is considered commercially insolvent when it incurs an inability to comply, at maturity, with the obligations acquired and that are represented in debts and liabilities with third parties, mainly because the cash flows, generated by the economic entity, are insufficient.

There are also other useful indicators to evaluate a company’s solvency, which have already been studied previously, mainly in the part corresponding to proportional financial statements, such as the “Long-term liabilities-Capital” relationships, “Long-term liabilities term-Equity” or the one presented below.

LONG TERM CAPITALIZATION

Measure that indicates the relative importance of long-term debt within the company’s capital structure, as already defined:

Long-term liabilities / Total capitalization

Historical Tight
362,215 / 868,041 330,392 / 1,244,142 362,215 / 939,059 330,392 / 1,338,525
0.4173 0.2656 0.3857 0.2468

The higher this indicator is, the greater the risk that the economic entity runs, since an unforeseen situation that affects the operating income of the company, decreasing it, could lead to a situation of illiquidity and insolvency, as a consequence of the high financial burden that long-term debts would cause. The denominator of this indicator is made up of the sum of long-term debts and the company’s equity, which is why it seems valid that the interpretation of results is made on inflation-adjusted figures.

Debt level

This indicator indicates the proportion in which creditors participate in the total value of the company. Likewise, it serves to identify the risk assumed by said creditors, the risk of the owners of the economic entity, and the convenience or inconvenience of the level of indebtedness presented. High indebtedness ratios can only be admitted when the rate of return on total assets is higher than the average cost of financing.

The rate of return on total assets is calculated as the product of comparing the profit with the number of assets owned by the company, as explained in the chapter corresponding to profitability indicators. On the other hand, the average cost of financing will be given by the rate that represents the interests caused in a period, concerning the average of financial obligations maintained during the same period; The income tax rate is deducted from the result thus obtained when the tax legislation allows the deductibility of the financial expenses incurred.

Passive active

Historical Tight
1,029,660 / 1,535,486 1,916,691 / 2,830,441 1,029,660 / 1,606,504 1,916,691 / 2,924,824
0.4173 0.2656 0.3857 0.2468

It can be seen in the results adjusted for inflation how the participation of the creditors “drops” from 67 percent to 65 percent. This is naturally due to the part of the inflation adjustments that are recorded as a higher value of their respective items and that in the income statement caused a profit of an “unrealized” nature. Consequently, this indicator must be analyzed without adjustments for inflation, because —otherwise— the erroneous conclusion of an improvement in the indebtedness ratios could be reached when, in reality, what is being done is increasing the value of total assets, up to an amount equivalent to its replacement cost.

For the same reason above, valuations should be subtracted from total assets, as well as liability accounts called “customer advances” and “deferred income”, since their nature is not properly a credit but rather they are recorded temporarily there. , while the association of its costs and expenses with the realization of income occurs, that is, while its causation occurs over time.

Number of times interest is earned

This indicator indicates the relationship that exists between the profits generated by the company and the financial costs and expenses incurred, as a consequence of short- and long-term liabilities. It measures the impact of financial costs and expenses on the profits generated in a given period, to evaluate the company’s ability to generate sufficient liquidity to cover this kind of expense.

Earnings before interest and taxes / Interest and financial expenses

Historical Tight
405,472 / 276,952 734,852 / 244,692 366,445 / 276,953 697,726 / 244,682
1.46 3.00 1.32 2.85

The value corresponding to the concept of “Earnings before interest and taxes” (numerator) of this indicator was calculated as follows:

Historical Tight
20X1 20X2 20X1 20X2
Net profit 85,913 361,317 46,886 324,191
More: important provision 42,607 128,842 42,607 128,843
Interests 276,952 244,692 276,952 244,692
Earnings Before Interest and Taxes 405,472 734,852 366,445 697,726

The lowest value determined between the numerators (before and after adjustments for inflation) amounting to $39,027 and $37,126, corresponds to the net result of adjustments for inflation, as follows:

20X1 20X2
cost of sales adjustment 25,576 29,004
Deferred amortization adjustment (expense) 989 11,252
Depreciation adjustment (expense) 2,562 8,416
Net balance debit (credit) 9,900 11.546-
Monetary correction 39,027 37,126

To calculate the indicator “Number of times interest is earned”, the value of the gain or loss due to “exposure to inflation” registered in the monetary correction account must be eliminated, since the said result has not been realized by the company. The gain or loss from exposure to inflation is defined as the net balance (debit or credit) recorded in the monetary correction account as a result of applying the comprehensive inflation adjustment system to non-monetary balance sheet items:

corrected
“Real” profit before interest and taxes 376,346 686,180
I pay “real” interest 276,953 244,682
1.36 2.80

From this, it can be concluded that, in reality, this company would have thirty-six cents in 20X1 and one and eighty cents in 20X2 to meet operating expenses, after fulfilling its contractual obligations, derived from previously acquired financial liabilities. Figures are very different from those reflected before eliminating the effect of inflation and “correcting” the error of recording the gain or loss from exposure to inflation.

Note that the adjusted profit for the calculation of this indicator includes the heading of “other income” or “non-operating income” which, by their very nature, should be excluded, since their magnitudes will hardly be realized or repeated. in the future.

Despite the corrections introduced in this indicator, before its definitive evaluation, some other factors that affect its calculation should be considered, such as:

  1. Interest and other capitalized financial expenses, because they come from financing fixed assets and accounting may not be affecting the statement of profit and loss. They should be added to the interest recorded as an expense for the period (denominator);
  2. The average interest rate must be corresponding (after including the capitalized financial expenses) with the average market rate, registered in the year being analyzed. If this is not the case, the cause will have to be sought, which may be determined by development loans (whose rate is lower than the commercial market rate) or by an incorrect accounting of liabilities or the undue deferral of interest or other financial expenses;
  3. On some occasions it is pertinent —and in fact, this is what some analysts recommend— to add to the denominator the number of disbursements that, by the concept of capital payments, have been made during the year being analyzed, as well as the rental fees for Leasing contracts in force during the period
  4. As it is a matter of measuring the capacity to generate resources that allow timely compliance with the fixed charges that have been assumed for financing, some authors recommend reconciling the utility by adding the “virtual” expenses that have affected the income statement, but that do not imply cash disbursements, such as depreciation and amortization of deferred assets. A similar refinement is made when preparing the statement of changes in financial position or the statement of cash flows, as explained in the next chapter.

Summarizing, this indicator indicates the number of times that the profits cover the immediate financial obligations of the company and, therefore, can determine its indebtedness capacity. The higher the indicator result, the better your future credit standing will be.

Reasons for activity

This class of ratios, also called turnover indicators, measure the degree of efficiency with which a company uses the different categories of assets it owns or uses in its operations, taking into account their speed of recovery, and expressing the result using indices or numbers. times.

Purse rotation

Establishes the number of times that accounts receivable return, on average, in a given period. Normally, the “sales” factor should correspond to credit sales, but since this value is not always available to the analyst, it is accepted to take the company’s total sales, regardless of whether they have been cash or credit. For its part, the denominator of this ratio is the average recorded in accounts receivable from customers or merchandise debtors, which is obtained by adding the initial balance to the final balance and dividing this total by two or —for greater precision— the average of the last twelve months.

Sales / Accounts Receivable

Historical
1,620,003 / 304,637 3,102,816 / 227,094
5.32 13.66

These results would be interpreted as follows: Accounts receivable for 20X1, which amounted to $304,637, were cashed 5.32 times during that period and 13.66 times during 20X2.

As these are items that do not undergo inflation adjustments, for the analyst it is indifferent to evaluate the turnover of accounts receivable, before or after the application of said comprehensive system of inflation adjustments.

The portfolio turnover indicator allows us to know the speed of the collection but it is not useful to evaluate if said rotation is by the credit policies established by the company. For this last comparison, it is necessary to calculate the number of days of turnover of accounts receivable.

Portfolio collection period

Once the number of times of turnover of accounts receivable is known, the days required to collect accounts and documents receivable from customers can be calculated. To do this, it is enough to divide the number of days considered for the analysis (30 days if it is a month or 365 if it is a year) by the rotation indicator, previously calculated:

Days / Rotation

Historical
365 / 5.32 365 / 13.66
69 27

Since it has been explained that it is indifferent to calculate this ratio based on historical or inflation-adjusted values, then it will be said that the company in the example took an average of 69 days to recover credit sales, during 20X1 and 27 days in 20X2, which It seems to demonstrate either that the company’s credit policy varied substantially from one period to another, or that a high degree of inefficiency was occurring in the area responsible for the portfolio.

The portfolio turnover indicator and the number of days of recovery of accounts receivable are used to be compared with averages for the sector to which the company being analyzed belongs or, as has already been said, with the policies set by the senior management of the economic entity. However, regarding this last point, it must be taken into account that several days for portfolio recovery that exceeds the established goals do not necessarily imply deficiencies in the corresponding area, as occurred with the example taken in this text because there could be some Few clients, whose balances are proportionally higher than the common client portfolio, are registering some delay in the fulfillment of their obligations or enjoys some special prerogative,

To avoid the previous problem, it is useful to classify accounts receivable according to their age, identifying the periods due in each case, more or less under the parameters allowed to establish provisions for accounts of difficult or doubtful collection, incorporated into tax regulations. and accountants.

Inventory turnover

It indicates the number of times that the different classes of inventories turn over during a given period or, in other words, the number of times that said inventories are converted into cash or accounts receivable.

Cost / Inventory

Historical Tight
986,266 / 257,561 2,066,098 / 518,045 1,011,842 / 257,561 2,095,102 / 518,045
3.83 3.99 3.93 3.95

In this case, it is correct that, for a better interpretation of the results, the value of the average inventories (denominator) remains at historical values ​​but, on the other hand, the value of the cost does incorporate the respective inflation adjustments, since said figure expresses the amount that the company should reserve to be able to operate normally, in conditions of inflation, or at least in the same volume of transactions registered in the immediately preceding period. Therefore, in addition to the adjustment for inflation from calculating depreciation from fixed assets and amortization of deferred, intangible and exhaustible assets, it should reflect the update of the other factors that make up the cost of production —such as inventory purchases,

corrected
Cost / Inventory 1,075,871 / 257,561 2,175,317 / 518,045
4.18 4.20

However, taking into account the previous correction, the interpretation cannot be made in the sense that inventory turnover improved with inflation (concerning historical values), but in the direction of pointing out that this company has had to rotate 4.18 times its inventory, in exchange for 3.83 times in 20X1; and 4.20 times in exchange for 3.99 times in 20X2, if it was intended to maintain certain stability in the purchasing power of the currency.

This “inventory turnover” indicator can —and should— be calculated for each type of inventory: raw materials, products in process, finished products, merchandise for sale, spare parts, and materials, among the most common, in which case the “cost” factor must be adapted to the circumstances (raw material consumed, cost of production, cost of sales or consumption, depending on whether it is one or another class of inventory); and the average inventory must be as representative as possible, hopefully, obtained with a long series of data (for example, the twelve months of the year), although the average of adding initial inventory with final inventory does not invalidate its result.

See also  75 Financial terms and their meaning

Inventory days

It is another way of measuring the efficiency in the use of inventories, only now the result is expressed not several times, but through the number of days of rotation.

Days / Rotation

Historical Tight
365 / 3.83 365 / 3.99 365 / 3.93 365 / 3.95
95 91 93 92

These results would indicate that the company converted its inventories into cash or accounts receivable (through sales) every 95 days and every 91 days, during 20X1 and 20X2, viewed from the point of view of figures not corrected for inflation and every 92 and 87 days, during the same periods, after eliminating the effect of the price variation in the depreciation calculation.

Will this be true? Not. A change in the numerator of the ratio must first be introduced (a change that was studied in the chapter on “inventory turnover”) and then its interpretation reassessed:

corrected
Days / Rotation 365 / 4.18 365 / 4.20
87 87

Figures that must be read and interpreted in the light of “what should be”. In other words, for this company to not be affected in terms of purchasing power, its inventory should return (turn into cash or accounts receivable) every 87 days and not every 95 or 91 days, during the two years under study.

Supplier rotation

It expresses the number of times that accounts payable to suppliers rotate during a determined period or, in other words, the number of times that such accounts payable are settled using the company’s liquid resources.

As the amount of purchases made during the year is not known in the exercise that has been carried out, they can be estimated through the known information: initial and final inventories and cost of sales. However, it should be stressed that the reason would be more complete if the volumes of inventory purchases made from suppliers were known exactly.

Tight corrected
Sales cost 986,266 2,066,098 1,011,842 2,095,102
Plus: Ending Inventory 257,561 518,045 257,561 518,045
available merchandise 1,243,827 2,584,183 1,269,403 2,613,147
Less: ending inventory 239,987 257,561 239,987 257,561
total purchases 1,003,840 2,326,582 1,029,416 2,355,586

Purchases / Suppliers

Historical Tight
1,003,840 / 45,681 2,326,582 / 110,826 1,029,416 / 45,681 2,355,586 / 110,826
21.97 20.99 22.53 21.25

These results would be interpreted as follows: Accounts payable to suppliers for 20X1, which amounted to $45,681, caused cash outflows 21.97 times in said period and 20.99 times during 20X2. However, by partially applying the comprehensive system of adjustments for inflation, the value of the purchases is expressed, also partially, in terms of currency on December 31 of each period, which is why the purchases should also be duly updated for inflation. To obtain the amount that it would cost to acquire the same volume of inventories, to continue operating normally, but at the new prices affected by inflation:

corrected
Purchases / Suppliers 1,090,865 / 45,681 2,424,458 / 110,826
23.84 21.88

Consequently, the indicator of turnover of accounts payable to suppliers must be calculated based on figures adjusted for inflation, since it relates a non-monetary item (purchases) with another monetary item (suppliers).

Purchase days in accounts payable

It is another way of measuring the outflow of resources to meet obligations acquired with suppliers for inventory purchases but expressing the result not several times but through the number of days of rotation.

Days / Rotation

Historical Tight
365 / 21.97 365 / 20.99 365 / 22.53 365 / 21.25
17 17 16 17

These results would indicate that the company canceled its debts with suppliers every 17 days, during 20X1 and 20X2, as seen from the point of view of figures not corrected for inflation, and every 16 and 17 days, during the same periods, after eliminating the effect of the price variation. Taking corrected figures, said days of rotation would change to 15 in the year 20X1, but would remain at 17 in 20X2

Net cycle to market

This indicator, which is calculated as several days, is useful to identify the magnitude of the investment required as working capital because it relates to the turnover of the three variables that directly intervene in the operating activity of a company: accounts receivable from customers, inventories, and accounts payable to suppliers. For its estimation, the results, in the number of days, of the rotations corresponding to each of the aforementioned concepts are taken:

Real
Number of days of portfolio 69 27
Number of days of inventory 87 87
Subtotal 156 114
Less: number of days of supplier rotation fifteen 17
Net cycle to market 141 97

Whose interpretation is none other than the estimation of the working capital requirements, which were 139 and 97 days, for each of the years analyzed. To the extent that this indicator is greater, it will mean that the company must also obtain greater amounts of money to meet its obligations with suppliers, which can be achieved, either through improving its collection or the efficiency in inventory rotation, or through new credits, a solution that is not the best, since it will imply additional financial costs, to the detriment of the rates of return.

Asset turnover

This class of indicators establishes the efficiency in the use of assets, by the administration, in its task of generating sales. There are as many kinds of relationships as there are asset accounts in an accounting catalog. However, the most commonly used asset turnover ratios are the following:

  1. Sales in cash and cash equivalents: The ratio between sales and cash balances indicates the causal relationship arising from the normal operations of the company and its availability to cover daily needs and have a prudent reserve for eventualities. The higher the ratio, the higher also the probability of a cash shortfall; which will cause having to go to other sources of financing
  2. Portfolio sales: It is a parameter that relates the commercial operations of the entity with the holding of unproductive resources in the portfolio. A result that is too low can indicate very broad credit policies or inefficiency in the work of collecting accounts receivable. It could also be an indication of payment problems, by one or more customers.
  3. Sales to inventories: As in the previous relationship, a low indicator could be a symptom of excess stock, slow-moving merchandise, or obsolete inventories. On the contrary, a turnover above the industry average would indicate insufficient investment in inventories, which could lead to market losses by not being able to meet new orders promptly.
  4. Sales to fixed assets: The relationship between these two variables refers to the total invested in property, plant, and equipment and its ability to produce and generate sales. Therefore, a low indicator, compared to the sector average, would be diagnosing potential excesses in installed capacity, or inefficiencies in the use of machinery or its technical obsolescence.

As can be seen, the intensity in the use of assets is always measured concerning sales because, normally, they are the ones that provide the opportunity to generate equity. For the same reason, the ratio of sales to total assets, as will be seen later, is essential for calculating performance indicators.

To illustrate the procedure and the interpretation of this class of indicators, the development of the relationship “sales to fixed assets” will be taken as an example.

Sales / Gross Fixed Assets

Historical Tight
1,620,003 / 574,661 3,102,816 / 1,384,524 1,620,003 / 702,486 3,102,816 / 1,566,740
2.82 2.24 2.31 1.98

The results of this indicator indicate that, for each peso invested in fixed assets, 2.82 pesos were generated in 20X1 and 2.24 in 20X2, in sales. When taking the figures after adjustments for inflation, the results change to 2.31 and 1.98, respectively.

It should be taken into account that turnover is calculated in pesos and, consequently, the real productivity of the company is not analyzed, for which it would be necessary to know, among other things, the number of articles manufactured, the installed capacity, and the sales and purchases of fixed assets during the period under review

There are some parameters of the general application when estimating asset turnover ratios that must be taken into account for a better interpretation of results. In the first place, if the level of assets changes considerably during the period analyzed, it is advisable to take the simple average, dividing the sum of the initial and final balances by two. On the other hand, a constant performance or with an increasing trend over time indicates an efficient administration of the assets and prevents a conjunctural expansion from being confused with a sustained growth of the company’s operations.

Profitability ratios

The profitability ratios, also called performance, are used to measure the efficiency of the company’s administration to control the costs and expenses that must be incurred and thus convert sales into profits or profits.

Traditionally, the profitability of companies is calculated using ratios such as asset turnover and profit margin. The combination of these two indicators explained below, results in the financial ratio called “Return on Investment” (RSI) and measures the overall profitability of the company. Known as the Dupont method, it is a way of integrating a profitability indicator with another activity to establish where the return on investment comes from: either the efficiency in the use of resources to produce sales or the net profit margin generated. for those sales.

This indicator tells the investor how the return on the investment made in the company is produced, through the return on equity and total assets.

Return on investment

Utility / Assets

Historical Tight
85,913 / 1,535,486 361,317 / 2,830,441 46,886 / 1,606,504 324,191 / 2,924,824
5.59% 12.77% 2.92% 11.08%

In the example analyzed, it can be seen that, after applying the comprehensive system of adjustments for inflation, the indicator drops notably in the two years of study, although with less intensity in 20X2. This fact is explained because the monetary correction account showed a debit balance (loss) decreasing the number of profits (the numerator of the ratio), despite also the slight increase in the value of the company’s total assets (product of the adjustments to investments and property, plant and equipment).

In the author’s opinion, one more correction should be made to the design of this important indicator, in the sense of eliminating the part of the profits or losses coming from the “holding of assets”, which are reflected in the monetary correction account: $9,900 – and $11,546, for 20X1 and 20X2, respectively. Said correction is made under the premise that such profits are “unrealized gains” and, consequently, cannot form part of the basis for calculating the real return on investment.

Under these conditions, the indicator would be estimated as follows:

corrected
Real profit / Assets 56,786 / 1,606,504 312,645 / 2,924,824
3.53% 10.69%

Results conclusively indicate that the estimated profitability over historical values ​​(before eliminating the effect of inflation) overestimates the operating efficiency of the company and its ability to generate profits.

But, where does the profitability of the example company come from? This information can be obtained by analyzing separately the two components of the “Return on Investment” indicator, ie “Asset Turnover” and “Profit Margin”.

Asset turnover

Asset turnover measures the efficiency with which available assets have been used to generate sales; It expresses how many monetary units (pesos) of sales have been generated for each monetary unit of available assets. Consequently, it establishes the efficiency in the use of assets, since the changes in this indicator also indicate the changes in said efficiency. However, in the presence of inflation, the result tends to present distortions, since sales represent a flow and are recorded in the average purchasing power currency of the period analyzed. Instead, the assets will be valued at their acquisition cost, which produces an underestimation of the power to generate sales for each peso invested in assets.

Sales / Assets

Historical Tight
20X1 20X2 20X1 20X2
1,620,003 / 1,535,486 3,102,816 / 2,830,441 1,620,003 / 1,606,504 3,102,816 / 2,924,824
1,055 1,096 1,008 1,061

Profit margin

It expresses the amount of profits obtained for each monetary unit of sales. This indicator measures the operating efficiency of the company, since any increase in its result indicates the company’s ability to increase its performance, given a stable level of sales. In periods of inflation, the volume of sales may increase, although the physical volume remains unchanged. Consequently, the cost of merchandise sold will also increase, but in less proportion to the increase in sales, since said costs will be valued at old prices (by their historical purchase value). Thus, the percentage increase in profits will be higher than the percentage increase in sales. As explained in the following calculation,

Profits/sales

Historical Tight
85,913 / 1,620,003 361,317 / 3,102,816 46,886 / 1,620,003 324,191 / 3,102,816
0.053 0.116 0.029 0.1045

If, as already seen, the effect of the «utility from asset holding» is eliminated (taken from table No. 14 «Monetary correction») then we would have:

corrected
Real profit / Sales 56,786 / 1,620,003 312,645 / 3,102,816
0.035 0.1008

With these inflation-adjusted and “corrected” results, it can be concluded that the profitability of this company comes from its efficiency in the use of physical resources (assets) to produce sales than from the net profit margin generated by said sales.

Return on equity

This indicator indicates, as its name indicates, the rate of return obtained by the owners of the company, concerning their investment represented in the patrimony registered in the accounts:

Utility / Equity

Historical Tight
85,913 / 505,826 361,317 / 913,750 46,886 / 576,844 324,191 / 1,008,133
16.98% 39.54% 8.13% 32.16%

But if the utility is refined, in the sense of eliminating the gain from holding assets:

corrected
Real profit / Equity 56,786 / 576,844 312,645 / 1,008,133
9.84% 31.01%

This means that, after correcting for adjusted profit, true profitability “drops” to 31 percent in year 20X2, whereas the prior period shows an increase in profitability.

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