University of Chicago
Type of paper: Thesis/Dissertation Chapter
Use of financial ratios in evaluating companies
Financial ratios are the indicators used by financial analyst to determine the general position of a certain organization. They are also known as economic ratios, are obtained in financial statements, and are relative to figures of two distinct periods. These ratios compare the direction organizations are taking within a specified period. They will therefore show the strengths and weaknesses in the firms in relation to others or a comparison between two timelines. These ratios are important to the shareholders as they are able to know the direction a company is going by the shift in its share. In addition, the managers depend on them to know where they are leading the organizations. Some of the main financial statements where these ratios are gotten fro include the balance sheet and the statement of cash flows. Easy Jet Company is one of the companies that maintains its financial ratios and has benefited a lot. Although these ratios have many useful benefits in evaluating the performance and management of companies, they also have many limitations.
Aspects of financial ratios that can be used include the liquidity ratio, which is the ability of an organization to pay the expenditures that are for a short period. Profitability ratios show the amount of dollars earned per sale of one item. Others include activity ratio, which indicates whether the company is capable of managing its total assets. The financial leverage ratio on the other hand shows the ability of the company meeting long term goals while shareholder ratio relates to amount of shares as per the stock. Finally, the return on investment ratio relates the amount of profit as per the assets used. Easy Jet Company uses these ratios and has benefits and limitations as discussed below.
Financial ratios have an advantage in comparing different companies in the market. They enable the companies to be kept together not keeping into consideration such factors as capital amount, amount of sales and the market control. This is because the ratios do not depend much on the amount of starting but the rate of change of that amount in relation to other companies or time (Troy, 2008 p. 58). They will tell the ability of a certain business to be able to pay its expenditure and probability of making a profit. Companies may, for example, boast of a high level of capital compared with other small ones, but when analysis is done from a perspective of rate of stock turnover. This may prove the smaller company is efficiently run. They therefore help in the comparison and the managers will be able to collect any problem that may be there and compete favorably.
They also help in analyzing a certain line of industries and upcoming young companies to gauge the industries they want to venture in. The ratios will help also to show fast growing industries and advise young entrepreneurs accordingly. Small companies will also be able to gauge themselves on their relevance in the market due to their contribution compared to the big ones. According to Weygandt (1996 p. 136), financial ratios also enable the shareholders and analysts to analyze stock valuation. Investors in this area will be able to gauge on the company worth investing in and those to avoid completely. This knowledge helps investors in investing their money where there is a likelihood of making a profit. The ratios will help the companies in performance and planning. To attract lenders and investors, companies may prepare a detailed report and convince them with the capability of the company. Managers are also motivated to work hard since the ratios will be seen by many and would expose their weaknesses.
On the other hand, the ratios have limitations. Many companies deal with different products in the market and comparing them directly may not be an effective way of showing the success or failure of a business. Some companies enjoy low number of days at the rate of stock turnover due to a certain season. Comparing its ratios with off-season will definitely show a negative trend, which should not show someone being responsible for it. Comparing it with others during the high season will convince shareholders that the company is making progress only to realize it was due to seasonal product. Using financial ratios to compare companies leads to misleading information to the managers and the investors. Due to the use of different environmental, cultural and structure of the market, financial ratios are not a good measure of success or failure of a company.
The ratios are affected by the level of inflation. Comparing a company’s financial ratio of a year without inflation with another year with high levels of inflation will not give a good result. The sales will be high, but the level of profit decreases, showing a negative trend which otherwise is not the case. This may cause loss of jobs and investors. The company may at last collapse not because of poor management but the financial ratios. There may also be a situation where the ratios used are a mixture of bad and good ones making it difficult to know the position of the company. Some companies operate departments in different industries. It therefore becomes difficult to come up with average ratios to measure the performance of the company. If these ratios are used well the results are insightful, but dangerous where when used mechanically.
According to Ablin, et al (2013 p. 142), Easy Jets payments to the employees increased from 476£m in 2012 to 517£m in the year 2013. This indicates an increase of 8% an indication that the company’s return on investment ratio has improved. This is marked by an increase from 317£m to 478£m a 51% increase in the total profit before tax which indicates appropriate strategies have been used. This includes the increase in the rate of income per seat, offset by the use of forward bookings and the purchase of additional A320 aircraft. Earnings per share increased 2013 as compared to 2012 with earnings per share increasing from 62.5 to 101.3 for basic and 61.7 to 100.0 for diluted increasing the shareholder ratio. The executive directors are employed and paid directly by the Easy jet airline company’s revenue.
Return on capital increased with the onset of 2013 from 2012. The rate changed from 11.3% to 17.4% indicating growth in the company. This is attributed to increase in the number of leased aircrafts from 26% in 2012 to 33% in 2013 (Easy Jet, 2013 p. 94-96). On May 2013, Easy jet entered into an agreement with Flybe for the exchange of some flying right in the airport of Gatwick. The shareholders approved the deal and on August the same year, $7 million was paid. This made the operations of the company effective, resulting in the increase in the return on capital. This is further explained by the shareholders decision to enter into a contract with Airbus in July 2013. In Easy Jet Switzerland S.A, the company has 49% shares and plans to own the remaining 51% by 2022.
Upgrading by the company’s management from a 156 seater A319 aircraft to A320 results to a saving in the cost of a seat by between 8% and 7%. There is also another cause of increased savings in the development and movement from 180 seat A320 to 180 new generation neo aircraft. This cause further 4% to 5% savings per seat. This has made the company to continue offering services to the ever-increasing number of customers as the company. There has also been the development where the company has changed in reducing its cash on deposit. This has increased the amount of cash that the company holds in liquid following the release of the £130 million previously held.
Financial ratios play an important role in determining the direction a company is taking. Like a driver who drives a vehicle, managers depend mostly on these ratios to determine the direction as drivers are heading the company. The companies are able to compare their performance in the market with others courtesy of these ratios. The ratios also have a role in enabling the investors and shareholders determine on which company is fit for them to invest. Similarly, they have drawbacks in that they do not reflect the true picture of a company’s position when there is inflation in the country in addition to company that deals with many departments within different lines of production. Easy Jet Company has successfully used these ratios effectively and has developed to be an excellent company competing effectively with others. It is therefore a successful company.
Ablin et al (2013). Easy jet plc (1st ed.). Switzerland: Park Communications.
Troy, L. (2008). Almanac of business and industrial financial ratios.Chicago, IL: CCH.
Weygandt, J. J., Kieso, D. E., &Kell, W. G. (1996). Accounting Principles (4th ed.). New York
Easy Jet. (2013). easyJet plc Annual report and accounts. Easy Jet plc