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 the loan 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 protection role, 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 ratios b. The use of standards for interpretations of ratios c. 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

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 current revenues. 2. Net profit margin will be overstated as depreciation on historical cost of fixed assets is charged against current revenues. 3. Return on investment is overstated because net income includes price gains whereas investments are understated at historical values. 4. Most turnover ratios are overstated because current revenue is divided by historical cost of assets. 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