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Financial Ratios in Contracts

Financial ratios have also found application in contracting. The most familiar use of financial

ratios is in negative bank loan covenants. Borrowing companies may be required not to violate certain

stipulated financial ratio levels.

1. A minimum current ratio or a maximum debt-equity ratio may be set for the duration of theloan agreement. Banks will then monitor conformity with the loan terms by periodically

evaluating the companys financial ratios.

2. May be given a bonus based on the attainment of a pre-set return on investment targets.Government regulations are partly based on financial ratios. Public utility rates are based on

rate of return limitations.

The basic usefulness of financial ratios in contracting lies in its quantitative and verifiable nature.

Before-the-fact, ratios serve to summarize the banks quality requirements for its clients financial

position, the board of directors aspiration of returns, and the regulatory agencys consumer protectionrole, among others. Once contracts are set, financial ratios serve to demonstrate the management

compliance with the agreement. These are certain limitations however, in the use of ratios for contracts.

First, an inordinate focus on ratios may create an incentive for management to misrepresent financial

statements and ratios. This potential problem should be kept in mind when monitoring compliance with

contracts. Second, accounting policies of companies can readily affect the financial ratios that there

could be instances whern financial ratios do not represent the corporate performance being monitored.

Further clarity in the defifinition of the ratios, including the financial statement accounts to be excluded

or included, would help minimize this problem.

TOWARD IMPROVED TECHNIQUES IN RATIO ANALYSIS

In spite of the preceding discussion regarding precise ration formulas and the application of

statistical techniques in financial ratios, the interpretation of computed ratios remains significantly a

qualitative and judgmental exercise. The financial analyst would need further guidelines on the

interpretations of the computed ratios. In the remaining sections of this chapter we will discuss:

a. The effects of inflation of ratiosb. The use of standards for interpretations of ratiosc.

The need to evaluate several interrelated ratios to draw up a comprehensive interpretation

of the companys financial position and performance.

INFLATION AND RATIO ANALYSIS

Inflation, coupled with certain accounting principles used in financial statements preparation,

has a way of reducing the relevance of the financial ratios. Specifically, inflation has the effect of

recognizing holding or price gains as finished goods acquired at old costs are sold at higher current

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prices. Similarly, with the inflation, the balance sheet will not necessarily reflect the current costs of the

assets. The following ratios, for example, will be affected:

1. Gross profit margin will be overstated as historical cost of goods is charged against more currentrevenues.

2. Net profit margin will be overstated as depreciation on historical cost of fixed assets is chargedagainst current revenues.

3. Return on investment is overstated because net income includes price gains whereasinvestments are understated at historical values.

4. Most turnover ratios are overstated because current revenue is divided by historical cost ofassets. The problem is minimized in the turnover ratios for inventory and recievables because

these are stated at relatively more current values.

The claim of overstatement in profitability should be taken in the context of the fact that

reported accounting profits can be disaggregated into a current profit and an inflation profit

component.

The company must survive under inflationary conditions and insulating managers from the risk

of inflation might cause them to be indifferent to the need to minimize the inflation risk through

appropriate asset management policies. Thus, such a separation of profits for performance evaluation is

meant to facilitate interpretations rather than to limit the scope of evaluation to cover controllable

factors only.

The analyst should exercise care when making inferences based on historical cost

financial ratios under inflationary conditions. The analyst