Financial Ratios Used In Annual Reports - Financial Reporting and Analysis

Financial ratios are used to interpret and explain financial statements. Used properly, they can be effective tools in evaluating a company’s liquidity, debt position, and profitability. Probably no tool is as effective in evaluating where a company has been financially and projecting its financial future as the proper use of financial ratios.

A firm can use its annual report effectively to relate financial data by the use of financial ratios. To determine how effectively firms use ratios to communicate financial data, the annual reports of 100 firms identified in the Fortune 500 industrial companies were reviewed. The 100 firms represented the first 20 of each 100 in the Fortune 500 list. The objective of this research project was to determine:

  1. which financial ratios were frequently reported inannual reports,
  2. where the ratios were disclosed in the annual reports,
  3. what computational methodology was used to compute these ratios.

Figure indicates the ratios disclosed most frequently in the annual reports reviewed and the section of the annual report where the ratios were located. The locations were the president’s letter, management discussion, management highlights, financial review, and financial summary. In many cases, the same ratio was located in several sections, so the numbers under the sections in Figure do not add up to the total number of annual reports where the ratio was included.

Seven ratios appeared more than 50% of the time in one section or another. These ratios and the number of times found were earnings per share (100), dividends per share (98), book value per share (84), working capital (81), return on equity (62), profit margin

Ratios Disclosed Most Frequently in Annual Reports*

Ratios Disclosed Most Frequently in Annual Reports*

(58), and effective tax rate (50). The current ratio was found 47 times, and the next ratio in order of disclosure, the debt / capital ratio, appeared 23 times. From this listing, we can conclude that profitability ratios and ratios related to investing were the most popular. Figure excludes ratios not disclosed at least five times.

Logically, profitability ratios and ratios related to investing were the most popular for inclusion in the annual report. Including ratios related to investing in the annual report makes sense because one of the annual report’s major objectives is to inform stockholders.

A review of the methodology used indicated that wide differences of opinion exist on how some of the ratios should be computed. This is especially true of the debt ratios. The two debt ratios most frequently disclosed were the debt / capital ratio and the debt / equity ratio. This book does not cover the debt / capital ratio. It is similar to the debt / equity ratio, except that the denominator includes sources of capital, in addition to stockholders’ equity.

The annual reports disclosed the debt / capital ratio 23 times and used 11 different formulas. One firm used average balance sheet amounts between the beginning and the end of the year, while 22 firms used ending balance sheet figures. The debt / equity ratio was disclosed 19 times, and 6 different formulas were used. All firms used the ending balance sheet accounts to compute the debt / equity ratio.

In general, no major effort is being made to explain financial results by the disclosure of financial ratios in annual reports. Several financial ratios that could be interpreted as important were not disclosed or were disclosed very infrequently. This is particularly important for ratios that cannot be reasonably computed by outsiders because of a lack of data such as accounts receivable turnover.

At present, no regulatory agency such as the SEC or the FASB accepts responsibility for determining either the content of financial ratios or the format of presentation for annual reports, except for the ratio earnings per share. Many practical and theoretical issues relate to the computation of financial ratios. As long as each firm can exercise its opinion as to the practical and theoretical issues, there will be a great divergence of opinion on how a particular ratio should be computed.

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