According to Weygandt et al. (1996), ratio analysis involves the selection, evaluation, and interpretation of financial information and data to help the management, creditors, shareholders, and taxation authorities in investment and financial decision-making. Ratio analysis is a tool that is utilized internally to evaluate issues such as credit policies, the efficiency of the company’s operations and employee performance and externally to assess potential investment opportunities and creditworthiness of debtors. Ratios analysis assists in the interpretation of the results of a firm so that the managers and shareholders can determine the financial position of the company and consequently evaluate whether they were a return on a certain undertaking/investment. They are used to test the solvency and profitability of an entity by examining its financial statements. Ratios are determined from financial statements and are crucial in making strategic decisions for the management since they provide meaningful information pertaining to liquidity, profitability, and efficiency of the company. They enable the management to conclude in respect of financial strength, position or weakness, and soundness of the company.
From prior studies, financial statements are statements that provide information about the profitability and the financial position of a business. It includes two statements, the income statement, and the balance sheet. The income statement presents the summary of the income earned and the expenses incurred during a financial year. Position statements present the financial position of the business at the end of the year. Ratio analysis involves establishing a meaningful relationship between various items of the two financial statements, that is, income statement and position statement. This paper will perform a combined ratio analysis, which includes time series and cross-sectional analysis (Taylor, 1993).
Current ratio, acid test ratio, and cash conversion ratio are examples of common liquidity ratios performed to estimate the firm’s ability to meet short-term obligations to creditors as they mature and become due. The current ratio is determined by dividing the current assets by the current liabilities. Assets and liabilities with maturities of 1 year and below are considered current for financial statement analysis. A current ratio of 2:1 is considered ideal for a normal situation but this is not always the case. Motion Limited has a current ratio of 2.3, 2.4, and 2.1 for the years 2009, 2010, and 2011 respectively. This ratio is above the minimum acceptable figure of 1:1; however, whether a certain ratio is satisfying depends on the nature of the firm’s operations and characteristics of its current assets and liabilities. A thorough comparison of Motion Limited with HTC, Nokia, and Apple shows that its current ratio is within the industry average of roughly 2.2.A low current ratio relative to industry averages indicates that the firm faces difficulties in meeting its obligations when they fall due. However, a higher current ratio does not specifically imply greater liquidity and may be an indicator that funds are not efficiently employed within the firm. Excessive amounts of accounts receivables, idle cash balances and inventory balances lead to high current ratio. If the current ratio is less than 1 then-current liabilities exceed current assets and the liquidity of Motion Limited would be threatened. The company (Motion) could improve on this ratio over the years by selling additional capital stock, borrowing additional long-term debt, converting non-current assets into current assets, selling unproductive fixed assets and retaining proceeds (Furr,1957).
The quick ratio is computed by dividing the sum of cash, marketable securities, and accounts receivable by the current liabilities. Quick ratio eliminates inventories from consideration because inventories are known to be the least liquid of the major current assets category, as they must initially be converted to sales. Motion limited quick ratios for the year 2009,2010 and 2011 is above 1.0, which is considered a reasonable liquid position in that immediate liquidation of marketable securities at their current values and the collection of all accounts receivables in addition to cash at hand would be sufficient to cover the company’s current liabilities. The quick ratio mimics the movement of the current ratio and a higher ratio allows limited dependence on the salability of inventory to meet current obligations.
Debt ratio indicates to which extent the assets of the firm have been financed using borrowed funds. It is calculated by dividing total liabilities/total assets. The higher the ratio the greater the risk related to the company’s business. Motion Limited has a low debt ratio relative to industry norms. This implies the use of more equity than debt, which means the business is running on low gear, and is more likely to earn fewer profits as opposed to a situation where debt is more than equity in that case the firm is likely to get a higher return on equity after paying interest. The ideal debt ratio is 0.5. Motion Limited has a ratio below 50%, which implies that most of its assets are financed through equity while Nokia is greater than 50% indicating the high leverage of the firm and most assets are financed through debt. Motion Limited has a ratio of 30.6% in 2011which indicates that 30.6% of the firm total assets have been financed by debt. In line with industry averages, Motion Limited’s debt ratio declined slightly between the years 2009-2010 and rose significantly in year 2011.
Wall & Raymond (1928) alludes that these ratios relate the financial performance on the income statement with balance entries. They measure the degree of effectiveness of asset utilization in business activities. The total asset turnover ratio is calculated by dividing net sales by the company’s total assets. This ratio signifies how effective the organization is utilizing its assets to produce sales or revenue. A typical manufacturing firm has a total asset turnover of 1.5. Motion Limited asset utilization was consistent between 2009-2010 and slightly increased in 2011.The firm(Motion) total asset turnover ratio is slightly larger than industry norms implying the company’s efficiency in employing the available resources. Motion Limited ratio for 2011 is 1.7, which means that the firm requires $1.7 of investment in assets to produce $1 in revenues.
The receivables turnover is calculated by dividing annual sales usually credit sales by the year-end accounts receivables. This ratio shows the effectiveness of collecting account receivables. Motion Limited’s receivables turnover in 2011 is 6.1, which means that the average collection period is 2 months (12 months divided by the turnover ratio of 6.1). Motion limited receivables turnover ratio slightly fell from 2009-2010.The firm(Motion) turnover ratio is higher than industry averages which may indicate a rigid internal credit policy that might result in lost sales.
Inventory turnover is computed by dividing the cost of sales by the average stock held during the year. The average stock is taken to be the average of opening and closing stock. The higher the inventory times in an operating cycle, the greater the profit. Motion Limited shows a slight increase from 2009-2011, an indication of a delicate balance between having to low an inventory turnover which increases the likelihood of holding obsolete inventory and a very high inventory turnover which could lead to stock-outs and lost sales. Motion Limited asset management ratios are favorable in comparison to industry averages.
These ratios show the firm’s ability to generate returns on its sales, assets, and equity. The net profit margin is a widely used measure of profitability, determined by dividing the firm’s net income after taxes divided by net sales. This ratio is also important as it shows the ability to earn a return after meeting interest and tax obligations. Motion Limited’s net profit improves slightly from 2010 to 2011.
Return on total assets is a ratio that measures the rate of return on total investment. It is computed by dividing net income by total assets and is usually calculated before interest and taxes. This ratio focuses on the company’s performance and ignores how the firm is financed and taxed. Motion Limited return on assets was consistent in those three years and within the industry norms. A low ratio in comparison to industry averages shows inefficient utilization of the firm’s assets.
The return on equity measures the return earned by the shareholders on their investment. This ratio is indicative of the fact that a part of the company’s assets is financed through borrowed funds. As with return on total assets, Motion Limited varied considerably from 2009-2011and is also above industry averages (Williams et al., 2008).
Furr, D.E. (1957). Ratio analysis of financial statements. California, CA: University of Richmond
Taylor, C.W. (1923). Ratio analysis of financial statements. University of Cincinnati
Wall A, & Raymond, W. D. (1928). Ratio analysis of financial statements. Harper
Weygandt, J. J., Kieso, D. E., & Kell, W. G. (1996). Accounting principles (4th ed.). New York, NY: John Wiley
Williams, J. R., Susan F. H., & Mark S. B. (2008). Financial & managerial accounting. McGraw-Hill Irwin. pp. 266.