What is the impact of consolidation on financial ratios?

Consolidation of financial results provide an overall view of the companies performance across various divisons,brances or entities in the business. It also smoothens variances in financial performance and can help with analysing the top level results and gives a more holistic overview of performance across various sectors.

Consolidation eliminates intercompany transactions and balances, affecting both assets and equity on the consolidated balance sheet. This can increase or decrease the consolidated equity ratio depending on the relative size and leverage of the individual entities: Increase: If subsidiaries have high equity compared to debt, consolidating them raises the overall equity, potentially increasing the consolidated equity ratio. Decrease: If subsidiaries rely heavily on debt, consolidation removes their individual debt while adding their assets, potentially lowering the consolidated equity ratio.

Overall Impact: The final impact on ROA depends on whether the added income from the subsidiaries grows at a faster or slower rate than the added assets: Higher Rate: ROA rises, indicating improved efficiency from consolidating profitable subsidiaries. Slower Rate: ROA decreases, suggesting the acquired assets underperform in generating returns. Equal Rate: ROA remains relatively unchanged.

Current ratio measures the liquidity of a business. It is calculated as total current assets minus the current liabilities of a business at a particular time.

Elimination of intercompany transactions: During consolidation, intercompany transactions and balances (e.g., receivables from one subsidiary owed by another) are eliminated. This reduces both current assets and current liabilities in the consolidated financial statements. Impact on ratio: Depending on the relative size of these eliminated items, the consolidated current ratio might be: Higher: If intercompany receivables were larger than payables. Lower: If intercompany payables were larger than receivables. Unchanged: If the two roughly balanced each other out.

Impact on D/E ratio: Elimination of intercompany transactions: Consolidation eliminates intercompany debt and equity held between the parent and its subsidiaries. This usually reduces both debt and equity, but the change in D/E ratio depends on their relative sizes. Effect of subsidiary leverage: If subsidiaries have higher D/E ratios than the parent, consolidation increases the consolidated D/E ratio. Conversely, lower D/E subsidiaries can decrease the consolidated ratio.

Uncertain: Whether the ratio goes up or down depends on the relative changes in sales and assets. If the increase in sales is proportionally larger than the increase in assets, the ratio increases, indicating potentially improved efficiency. If the increase in assets is proportionally larger than the increase in sales, the ratio decreases, indicating potentially reduced efficiency.

When analyzing financial ratios from consolidated financial statements, we must approach with caution. This caution becomes even more critical when the consolidation covers various types of businesses. The main concern is that consolidation can sometimes obscure the real issues. For instance, a business facing profitability or liquidity challenges might not seem problematic once its figures are merged with those of a more successful company. This means the consolidated numbers could mislead us by hiding the financial struggles of one part of the business. Therefore, it’s essential to look beyond the surface of consolidated ratios to understand the actual financial condition of each entity involved.