Ratio Analysis of Financial Statements
Horizontal and Vertical Analyses compare one figure to another within the same category and ignore figures from different categories.
But it is also essential to compare figures from different categories. Ratio Analysis provides this comparison. Ratio Analysis is a comparison of relationships among account balances.
Any analysis of Financial Statements involves the calculation of various ratios:
A ratio is:
A relationship between two numbers. It is usually expressed as “a to b” or a : b. Sometimes it expressed as a quotient of the two numbers. A ratio shows how many times the first number contains the second number.
For example, an Assets to Sales Ratio = Total Assets / Net Sales
Say you have $100,000 in Total Assets, and $1,000,000 in Net Sales, your Assets to Sales would be 100,000 / 1,000,000 or 1 : 10 or 1/10 = .10 or 10%
In other words, Financial Ratios compare relationships among entries from a company’s financial information.
At a basic level, ratios make two types of comparisons: Industry comparisons and trend analysis.
- Trend analysis– Comparing a company’s performance from one period to another (current year vs last year, etc.).
Trend analysis examines ratios over comparable periods. Compare a firm’s present ratio with its past to project expected future ratios. Then, you can determine whether the company’s financial condition is improving or deteriorating over time. This analysis determines the future viability of the business.
- Industry comparisons– Comparing a company’s performance to industry peers (benchmarking).
In industry comparisons, compare the ratios of a firm with those of similar firms or with average industry ratios to gain insight. Industry average financial ratios are available from various sources, such as:
- Bradstreet
- Robert Morris Associates
- IndustriusCFO
Financial Ratios are important because they give you a standardized measure. So you can compare and track performance over time and against industry peers.
So as in our example, once you determine a ratio such as Assets to Sales, then, you refer to some comparative data to determine how your company is performing on this Key Performance Indicator (KPI) or ratio.
Comparative data may be:
- a general rule of thumb
- a comparison to the previous year’s performance
- a comparison against industry peers in benchmarking.
The rule of thumb here is, the smaller the number or percentage, the better. It’s telling you that your company is able to generate more Sales with less assets. Whereas a less efficient firm is generating equal Sales with more assets.
In another example, consider Company A & Company B. Company A is able to generate 1M in Net Sales with $100k in Total Assets. Company B is able to generate 1M in Net Sales with $500k in Total Assets. Company A has Assets to Sales of .10 or 10%, Company B’s is .50 or 50%. Since the smaller the Assets to Sales number the better, Company A is more efficient in their use of Total Assets to generate Net Sales. Whereas, the higher the number, efficiency decreases.
Interested parties (such as creditors, investors, and managers) use the information from analysis to determine the strength or weakness of a company.
The analysis states a firm’s financial position relative to that of others firms, both peers and competitors and in relation to the firm’s own past performance.
The analysis helps create a firm’s financial reputation. It determines how investors and creditors view the entity’s financial position and operating results. This reputation will impact the firm’s power to:
- access credit
- find investors
- determine a growth or exit strategy
- improve business operations.
After completing the key ratio analysis of financial statements, the owner of a business should consult with management to chalk out, discuss, and amend plans for capturing opportunities and avoiding possible threats for the firm. A primary focus should be problem areas identified in the analysis, and their possible solutions.
Note that the Income Statement shows a company’s profit or loss, while the Balance Sheet itemizes the value of its Assets, Liabilities, and owners’ Equity. Together, the two statements provide the means to answer two critical questions:
- How much did the firm make or lose?
- How much is the firm worth based on historical values found on the Balance Sheet?
Ratio analysis is the calculations that measure an organization’s financial health; it brings complex information from the Income Statement and Balance Sheet into sharper focus for the owner. Particularly, it can measure and compare the organization’s productivity, profitability, and financing mix with other similar entities.
Again, looking at ratios in isolation is as useful as staring at a blank paper; it gives you almost no information. But, placed in the context of other reported items and the reported items of the competitors, it can provide meaningful indications.
There are many ratios that an analyst can use, depending upon the nature of relationship between the figures and the objectives of the analysis.
There are five general classes of financial ratios:
- Liquidity Ratios
- Activity Ratios
- Leverage Ratios
- Profitability Ratios
- Market Value Ratios
Ratio Analysis: Liquidity Ratios
For the purposes of illustration of financial ratios, let’s use a standard Balance Sheet:
And a standard Income Statement:
Liquidity Ratios
Liquidity ratios are the ratios that measure the speed with which a company can turn its Assets into Cash to meet short-term Debt. It is a company’s ability to meet its maturing short-term obligations. This knowledge is a must for conducting business activity in the face of adverse conditions such as during a labor strike, or due to an economic recession.
Liquidity ratios compare Current (short-term) Assets to Current Liabilities to show the speed with which a company can turn its Assets into Cash to meet Debts as they fall due. High liquidity ratios meet a creditor’s need for safety. But, they may also show that the organization is not using its Current Assets efficiently or that it is not putting its liquidity to use to make money.
Poor liquidity is analogous to a person who has a fever; it is a symptom of a fundamental business problem. It must receive the owner’s attention to avoid big problems before the business being unavoidably detained in a trap.
Liquidity ratios are static in nature: You must look at expected future Cash Flows to have a more accurate view of the situation. If future Cash Out-Flows are expected to be high relative to In-Flows, the liquidity position of the company will deteriorate, and vice versa.
Let us have a closer look at the ratios within this category:
Liquidity: Net Working Capital
Net Working Capital (or simply, ‘working capital’) is equal to Current Assets LESS Current Liabilities. We already know the definition of Current Assets and Current Liabilities:
Current Assets are those Assets which are expected to be converted into Cash or used up within one period or one year; whereas Current Liabilities are those Liabilities which must be paid within one period or one year.
You should pay Current Liabilities out of Current Assets.
So, there exists a need to match them. The value of Net Working Capital matches them to have a meaningful dollar amount. This dollar amount, known as net working capital, is a safety cushion to creditors. A large balance is required when a company has difficulty borrowing on short notice. For example, a labor strike can create periods of unproductive efforts to bring the business back on track. A good liquidity position will keep the business afloat in these types of situations.
Net Working Capital for the Learning Company for 2014 is:
Current Assets – Current Liabilities = Net Working Capital
In our Balance Sheet illustration, Current Assets is $120,000 and our Current Liabilities is made up of Payroll and Short Term Debt equaling $55,400 so the Net Working Capital is
$120,000 – $55,400 = $64,600
It was $60,000 in the previous year ($110,000 – $50,000). Therefore, the liquidity position has improved from one year to the next. This increase in net working capital is a favorable sign. Our sample company, The Learning Company, is doing well on liquidity front.
Note that the Net Working Capital is a difference of two dollar amounts. So, it is measured in dollars as well. It is simply a comparison which uses subtraction, unlike ratios, which uses division.
Liquidity: Current Ratio
The Current Ratio is equal to Current Assets divided by Current Liabilities. This ratio, which can be subject to seasonal fluctuations, is used to measure the ability of an enterprise to meet its Current Liabilities out of Current Assets.
A high ratio is needed when the firm has difficulty borrowing on short notice. A limitation of this ratio is that it may rise just before financial distress because of a company’s desire to improve its Cash position by, for example, selling fixed Assets. Such dispositions have a detrimental effect upon productive capacity. Another limitation of the Current Ratio is that it will be excessively high when Inventory is carried on the last-in, first-out (LIFO) basis.
The Learning Company’s Current Ratio for 2014 is:
Current Assets / Current Liabilities = Current Ratio
$120,000 / $55,400 = 2.17
Calculate the Current ratio is by dividing Current Assets by Current Liabilities. The Current ratio for 2014 is 2.17; it indicates that for every $1 of Current Liabilities, the firm has 2.17 of Current Assets on hand. In 2013, the Current ratio was 2.2, a slightly higher amount of Current Assets for each dollar of Current Liabilities. The ratio showed a slight decline over the year.
Note that the Current ratio has no units. It is just a comparison using division.
Liquidity: Quick Ratio
A Quick Ratio is a stringent measure of liquidity which eliminates Inventory while assessing liquidity. It is also known as the acid-test ratio. Calculate a Quick Ratio by dividing the most liquid Current Assets (Cash, marketable securities, and accounts receivable) by Current Liabilities.
Note that Inventory is *NOT* included because of the length of time needed to convert Inventory into Cash. Prepaid expenses are also *NOT* included because they also take time to convert into Cash.
This means that you need to remove two items, both the Inventory and prepaid expenses, to arrive at a dollar amount for your most liquid Assets. Your most liquid Assets should be capable of covering your Current Liabilities.
The formula to calculate Quick Ratio is:
Current Assets – (Inventory + Prepaid Expenses)/Current Liabilities = Quick Ratio
So, the Quick Ratio for the Learning Company in 2014 is:
Current Assets – (Inventory + Prepaid Expenses)/Current Liabilities = Quick Ratio
$120,000-($50,000+0)/$55,400 =
$70,000/$55,400 = 1.26
This ratio was 1.3 in 2013 ($65,000/$50,000); it went down over the year.
Because this ratio eliminates Inventory (the least liquid Current Asset), it measures how well an organization can meet its current obligations without resorting to the sale of its Inventory.
Ratio Analysis: Activity Ratios
For the purposes of illustration of financial ratios, let’s use a standard Balance Sheet:
And a standard Income Statement:
Activity Ratios
Another name for Activity Ratios is Asset Utilization Ratios. These ratios determine how fast various accounts can move into Sales or Cash. Liquidity Ratios generally do not give an adequate picture of a company’s real liquidity because differences exist in the kinds of Current Assets and Liabilities the company holds. So, it is more useful to check the activity of specific current accounts. Examples of items put to analysis would be Receivables, Inventory and Total Assets.
In a mathematical sense, Asset Utilization Ratios measure how well a firm uses its Assets to generate each dollar of Sales. Companies that use their Assets more productively will have higher returns on Assets than their less efficient competitors. Likewise, a businessperson can use Asset Utilization Ratios to pinpoint areas of inefficiency in their operations.
Let us have a closer look at the ratios in this category.
Activity: Accounts Receivable Ratios
No payments means no profits. Any business owner knows this well and so, he or she is interested in their business’ Accounts Receivable Ratio.
Accounts Receivable Ratios consist of two items:
- Accounts Receivable Turnover Ratio
- Average Collection Period.
The Accounts Receivable Turnover Ratio tells us the number of times Accounts Receivable is collected during the year.
Calculate it by dividing Net Credit Sales or Total Sales by the Average Accounts Receivable.
Find the Average Accounts Receivable by adding the beginning and ending accounts receivable numbers and dividing the sum by 2. Then, divide this average by either Total Sales or the Net Credit Sales (just be consistent from one year to the next so you are comparing like numbers.
In general, the higher the Accounts Receivable Turnover Ratio, the better: it shows quick collection from customers and re-investment of the received money. But, a high ratio may show an over stringent credit policy which is an imprudent use of funds.
Learning Company’s Average Accounts Receivable for 2014 is:
(Beginning Accounts Receivable + Ending Accounts Receivable)/2 =
($15,000 + $20,000) / 2 =
35,000 / 2 = $17,500
Likewise,
The Accounts Receivable Turnover Ratio for 2014 is:
Average Accounts Receivable / Total Sales =
17,500/100,000 = .175
In 2013, the Accounts Receivable Turnover Ratio was .816. The drop in this ratio indicates a serious problem in collection from customers. The issue may be due to loose billing and collection practices. So, the company should check its credit policy to control the problem.
To see the whole picture, the company should also examine the average length of time that it takes to collect on Receivables by determining the Collection Period.
The Collection Period is the number of days it takes to collect on Receivables. Typically, it is the number of days Sales remain in Accounts Receivable before receiving payment.
To calculate the Average Collection Period, take the number of working days possible in a year, and multiply it by the Average Accounts Receivable, then divide by net credit Sales or Total Sales:
(Number of Working Days * Average Accounts Receivable)/Total Sales
The Learning Company’s Average Collection Period for 2014 is:
(300 * $17,500) / $100,000 =
52,500,000 / $100,000 = 55.5 days
So, if it took 55 and a half days for a sale to be converted into Cash. In 2013, the collection period was 44.7 days. This large increase in collection days in 2014 is dangerously long – almost 2 months (60 days) and so the balances may become uncollectible. A possible cause might be that the company is selling to highly marginal customers with bad or dubious credit or means of payment.
In response to this information, the owner should identify delinquent customer balances and prepare an Aging Schedule. An Aging Schedule is a list of the accounts receivable according to the length of time they are outstanding. The Aging Schedule would be helpful in taking remedial actions for collections and halt future Sales until prior payment is received.
The company may also want to consider its credit terms, rather than payment being due in 30 days, make terms due in only 15 days.
Activity: Inventory Ratios
For a business, holding an optimum level of Inventory is vital because it avoids unnecessary trapping of Cash in Inventory but a business must have enough Inventory on hand to cover Sales.
For example, if a company is holding excess Inventory, it means funds that could be invested elsewhere are being tied up in Inventory and there will also be carrying costs for storage of the goods. Moreover, there’s a risk of the Inventory becoming obsolete. But, if Inventory is too low, the company may lose customers. So, holding an optimum level of Inventory is essential to the success of a business.
Before proceeding further, a business owner must understand Inventory Valuation. Inventory represents goods, raw materials, parts, components, or feedstock, amongst other things. Businesses use different accounting techniques to assign value to their Inventory. These techniques aid in managing Inventory quantities, and its valuation.
Two common methods used for managing Inventory are FIFO and LIFO.
- FIFO stands for first-in, first-out. It means that the oldest Inventory items are recorded as sold first.
- LIFO stands for last in, first-out. This means that the most recently produced or purchased items are recorded as sold first. This method reduces income taxes in times of inflation by decreasing net income. So, companies tend to use LIFO.
The difference between the cost of an Inventory calculated under the FIFO and LIFO methods is known as the LIFO reserve. It is the amount by which a company has deferred income tax by adopting LIFO.
A businessperson has two major ratios for evaluating Inventory:
- Inventory Turnover
- Average Age of Inventory
Inventory Turnover equals Average Value of Inventory divided by Cost of Goods.
Inventory Turnover indicates how many times a firm sells and replaces its Inventory over the course of a year. A high Inventory Turnover ratio may show great efficiency but may also suggest the possibility of lost Sales due to insufficient stock levels.
Calculate the average value of Inventory by adding the beginning and ending inventories and dividing the sum by 2.
For the Learning Company, the Average Value of Inventory in 2014 is
(Beginning Value of Inventory + Ending Value of Inventory) /2 = Average Value of Inventory
($45,000 + $50,000) / 2 =
$95,000 / 2 = $47,500
Likewise,
The Inventory Turnover is calculated by
Average Value of Inventory / Cost of Goods = Inventory Turnover
$47,500 / $50,000= .95
In 2013, it was 1.26 times.
This decline in the Inventory Turnover indicates the stockpiling of goods. The Inventory is turning over less frequently. So, a business owner identifies the specific items of non-selling Inventory. For example, items that are obsolete, damaged, or unpopular to determine if a sale or more marketing will help move the Inventory. But, a stockpile of goods may not be a concern at the introduction stage of a product in stock.
Average Age of Inventory shows how many days it takes, on average, to move items from going into Inventory to being sold out of Inventory.
The Average Age of Inventory is:
365 days in a year / Inventory Turnover
The Average Age of Inventory in 2014 is:
365 days in a year / Inventory Turnover
365 /. 95 = 346.75 days
The Learning Company is holding Inventory for almost an entire year. A longer holding period shows a strong risk of obsolescence. This length of time shows an incredible risk and is an issue that needs to be addressed. You can move Inventory faster or stockpile less of it and hold it within the typical Sales cycle. In 2013, it was 289.7 days. So, over the past year the average age of Inventory has increased even more, showing a perpetual problem that is not resolved and, in fact, has worsened.
Activity: Operating Cycle
The Operating Cycle of a business is the number of days it takes to convert Inventory and Receivables to Cash. So, every business desires a short operating cycle or an earlier conversion of Inventory into Cash.
An Operating Cycle is:
Age of Inventory + Collection Period = Operating Cycle
The operating cycle for the Learning Company in 2012 is:
Age of Inventory + Collection Period = Operating Cycle
346.75 + 55.5 = 402.25
In 2013, it was 334.4 days. This increase in length of the operating cycle is a significantly unfavorable trend; because, it ties up money in Non-Cash Assets for a longer period and risks loss in obsolete Inventory and in delinquent, unpaid receipts.
Activity: Total Asset Turnover Ratio
Total Asset Turnover is a financial ratio that measures the efficiency of a company’s use of its Assets in generating Sales Revenue or Sales Income to the company.
A business owner has a keen interest in how well his Assets generate earnings. Normally, companies with low profit margins tend to have high Asset Turnover, while those with high profit margins have low Asset Turnover. Retail businesses tend to have a very high Turnover Ratio due competitive pricing.
For a business owner, the Total Asset Turnover ratio is helpful in evaluating a company’s ability to use its Asset base efficiently to generate revenue.
A low ratio may be due to many factors. For instance, if the company’s investment in Assets is excessive when compared to the value of the output or Sales. In this case, the company might want to consolidate its present operation.
The Total Asset Turnover ratio is:
Total Sales / Average Total Assets = Total Asset Turnover Ratio
In 2014 the Total Asset Turnover ratio for the Learning Company is:
Total Sales / ((Beginning Total Assets + Ending Total Assets) / 2) =
$100,000 / (($200,000 + $220,000) / 2)) =
$100,000 / $210,000 = .476
In 2013, the ratio was 0.485. So, the company’s use of Assets has declined significantly. A business owner will want to try and pinpoint the reasons for this ineffective use of Assets to generate Sales. A cause could be, for instance, that the machines are in need of repairs.
Ratio Analysis: Activity Ratios
For the purposes of illustration of financial ratios, let’s use a standard Balance Sheet:
And a standard Income Statement:
Activity Ratios
Another name for Activity Ratios is Asset Utilization Ratios. These ratios determine how fast various accounts can move into Sales or Cash. Liquidity Ratios generally do not give an adequate picture of a company’s real liquidity because differences exist in the kinds of Current Assets and Liabilities the company holds. So, it is more useful to check the activity of specific current accounts. Examples of items put to analysis would be Receivables, Inventory and Total Assets.
In a mathematical sense, Asset Utilization Ratios measure how well a firm uses its Assets to generate each dollar of Sales. Companies that use their Assets more productively will have higher returns on Assets than their less efficient competitors. Likewise, a businessperson can use Asset Utilization Ratios to pinpoint areas of inefficiency in their operations.
Let us have a closer look at the ratios in this category.
Activity: Accounts Receivable Ratios
No payments means no profits. Any business owner knows this well and so, he or she is interested in their business’ Accounts Receivable Ratio.
Accounts Receivable Ratios consist of two items:
- Accounts Receivable Turnover Ratio
- Average Collection Period.
The Accounts Receivable Turnover Ratio tells us the number of times Accounts Receivable is collected during the year.
Calculate it by dividing Net Credit Sales or Total Sales by the Average Accounts Receivable.
Find the Average Accounts Receivable by adding the beginning and ending accounts receivable numbers and dividing the sum by 2. Then, divide this average by either Total Sales or the Net Credit Sales (just be consistent from one year to the next so you are comparing like numbers.
In general, the higher the Accounts Receivable Turnover Ratio, the better: it shows quick collection from customers and re-investment of the received money. But, a high ratio may show an over stringent credit policy which is an imprudent use of funds.
Learning Company’s Average Accounts Receivable for 2014 is:
(Beginning Accounts Receivable + Ending Accounts Receivable)/2 =
($15,000 + $20,000) / 2 =
35,000 / 2 = $17,500
Likewise,
The Accounts Receivable Turnover Ratio for 2014 is:
Average Accounts Receivable / Total Sales =
17,500/100,000 = .175
In 2013, the Accounts Receivable Turnover Ratio was .816. The drop in this ratio indicates a serious problem in collection from customers. The issue may be due to loose billing and collection practices. So, the company should check its credit policy to control the problem.
To see the whole picture, the company should also examine the average length of time that it takes to collect on Receivables by determining the Collection Period.
The Collection Period is the number of days it takes to collect on Receivables. Typically, it is the number of days Sales remain in Accounts Receivable before receiving payment.
To calculate the Average Collection Period, take the number of working days possible in a year, and multiply it by the Average Accounts Receivable, then divide by net credit Sales or Total Sales:
(Number of Working Days * Average Accounts Receivable)/Total Sales
The Learning Company’s Average Collection Period for 2014 is:
(300 * $17,500) / $100,000 =
52,500,000 / $100,000 = 55.5 days
So, if it took 55 and a half days for a sale to be converted into Cash. In 2013, the collection period was 44.7 days. This large increase in collection days in 2014 is dangerously long – almost 2 months (60 days) and so the balances may become uncollectible. A possible cause might be that the company is selling to highly marginal customers with bad or dubious credit or means of payment.
In response to this information, the owner should identify delinquent customer balances and prepare an Aging Schedule. An Aging Schedule is a list of the accounts receivable according to the length of time they are outstanding. The Aging Schedule would be helpful in taking remedial actions for collections and halt future Sales until prior payment is received.
The company may also want to consider its credit terms, rather than payment being due in 30 days, make terms due in only 15 days.
Activity: Inventory Ratios
For a business, holding an optimum level of Inventory is vital because it avoids unnecessary trapping of Cash in Inventory but a business must have enough Inventory on hand to cover Sales.
For example, if a company is holding excess Inventory, it means funds that could be invested elsewhere are being tied up in Inventory and there will also be carrying costs for storage of the goods. Moreover, there’s a risk of the Inventory becoming obsolete. But, if Inventory is too low, the company may lose customers. So, holding an optimum level of Inventory is essential to the success of a business.
Before proceeding further, a business owner must understand Inventory Valuation. Inventory represents goods, raw materials, parts, components, or feedstock, amongst other things. Businesses use different accounting techniques to assign value to their Inventory. These techniques aid in managing Inventory quantities, and its valuation.
Two common methods used for managing Inventory are FIFO and LIFO.
- FIFO stands for first-in, first-out. It means that the oldest Inventory items are recorded as sold first.
- LIFO stands for last in, first-out. This means that the most recently produced or purchased items are recorded as sold first. This method reduces income taxes in times of inflation by decreasing net income. So, companies tend to use LIFO.
The difference between the cost of an Inventory calculated under the FIFO and LIFO methods is known as the LIFO reserve. It is the amount by which a company has deferred income tax by adopting LIFO.
A businessperson has two major ratios for evaluating Inventory:
- Inventory Turnover
- Average Age of Inventory
Inventory Turnover equals Average Value of Inventory divided by Cost of Goods.
Inventory Turnover indicates how many times a firm sells and replaces its Inventory over the course of a year. A high Inventory Turnover ratio may show great efficiency but may also suggest the possibility of lost Sales due to insufficient stock levels.
Calculate the average value of Inventory by adding the beginning and ending inventories and dividing the sum by 2.
For the Learning Company, the Average Value of Inventory in 2014 is
(Beginning Value of Inventory + Ending Value of Inventory) /2 = Average Value of Inventory
($45,000 + $50,000) / 2 =
$95,000 / 2 = $47,500
Likewise,
The Inventory Turnover is calculated by
Average Value of Inventory / Cost of Goods = Inventory Turnover
$47,500 / $50,000= .95
In 2013, it was 1.26 times.
This decline in the Inventory Turnover indicates the stockpiling of goods. The Inventory is turning over less frequently. So, a business owner identifies the specific items of non-selling Inventory. For example, items that are obsolete, damaged, or unpopular to determine if a sale or more marketing will help move the Inventory. But, a stockpile of goods may not be a concern at the introduction stage of a product in stock.
Average Age of Inventory shows how many days it takes, on average, to move items from going into Inventory to being sold out of Inventory.
The Average Age of Inventory is:
365 days in a year / Inventory Turnover
The Average Age of Inventory in 2014 is:
365 days in a year / Inventory Turnover
365 /. 95 = 346.75 days
The Learning Company is holding Inventory for almost an entire year. A longer holding period shows a strong risk of obsolescence. This length of time shows an incredible risk and is an issue that needs to be addressed. You can move Inventory faster or stockpile less of it and hold it within the typical Sales cycle. In 2013, it was 289.7 days. So, over the past year the average age of Inventory has increased even more, showing a perpetual problem that is not resolved and, in fact, has worsened.
Activity: Operating Cycle
The Operating Cycle of a business is the number of days it takes to convert Inventory and Receivables to Cash. So, every business desires a short operating cycle or an earlier conversion of Inventory into Cash.
An Operating Cycle is:
Age of Inventory + Collection Period = Operating Cycle
The operating cycle for the Learning Company in 2012 is:
Age of Inventory + Collection Period = Operating Cycle
346.75 + 55.5 = 402.25
In 2013, it was 334.4 days. This increase in length of the operating cycle is a significantly unfavorable trend; because, it ties up money in Non-Cash Assets for a longer period and risks loss in obsolete Inventory and in delinquent, unpaid receipts.
Activity: Total Asset Turnover Ratio
Total Asset Turnover is a financial ratio that measures the efficiency of a company’s use of its Assets in generating Sales Revenue or Sales Income to the company.
A business owner has a keen interest in how well his Assets generate earnings. Normally, companies with low profit margins tend to have high Asset Turnover, while those with high profit margins have low Asset Turnover. Retail businesses tend to have a very high Turnover Ratio due competitive pricing.
For a business owner, the Total Asset Turnover ratio is helpful in evaluating a company’s ability to use its Asset base efficiently to generate revenue.
A low ratio may be due to many factors. For instance, if the company’s investment in Assets is excessive when compared to the value of the output or Sales. In this case, the company might want to consolidate its present operation.
The Total Asset Turnover ratio is:
Total Sales / Average Total Assets = Total Asset Turnover Ratio
In 2014 the Total Asset Turnover ratio for the Learning Company is:
Total Sales / ((Beginning Total Assets + Ending Total Assets) / 2) =
$100,000 / (($200,000 + $220,000) / 2)) =
$100,000 / $210,000 = .476
In 2013, the ratio was 0.485. So, the company’s use of Assets has declined significantly. A business owner will want to try and pinpoint the reasons for this ineffective use of Assets to generate Sales. A cause could be, for instance, that the machines are in need of repairs.
Ratio Analysis: Leverage Ratios
For the purposes of illustration of financial ratios, let’s use a standard Balance Sheet:
And a standard Income Statement:
Leverage Ratios
Any business owner does not want his or her business to go bankrupt. One can judge solvency of a business by using Leverage ratios.
Leverage ratios are also called Solvency Ratios and Long-Term Debt Ratios. Solvency is a company’s ability to meet its long-term obligations as they become due. Analysis of solvency concentrates on the long-term financial and operating structure of the business. Solvency is dependent on profitability since in the end, a firm will not be able to meet its Debts unless it is profitable.
In a situation where Debt is excessive, a business should seek extra financing from Equity sources such as investors rather than creditors.
Let us have a closer look at the different kinds of ratios classified as leverage ratios.
Leverage: Debt Ratio
A business owner must pay close attention to the composition of financing for the business.
Debt Ratio is a financial ratio that indicates the percentage of a company’s Assets financed through Debt. It is the ratio of Total Debts to Assets, including Fixed Assets and Intangible Assets. So, the Debt Ratio compares Total Liabilities (Total Debt) to Total Assets.
Debt Ratio shows the percentage of total funds obtained from creditors.
Creditors want a low Debt Ratio because there is a greater cushion for creditor losses if the firm goes bankrupt. The lower the Debt Ratio, the more solvent the company. Likewise, a high Debt-to-Assets Ratio may show a low borrowing capacity of a firm. So, a high Debt Ratio means lower financial flexibility for a business. As with all financial ratios, it makes sense to compare this ratio with that of others in the industry to gain insight.
The Debt Ratio is:
Total Liabilities / Total Assets = Debt Ratio
For the Learning Company, in 2014, the Debt ratio is:
$135,400 / $220,000 = .62
In 2013, it was 0.63. Since the Debt Ratio has decreased, there is a slight improvement in the ratio. But, the Debt Ratio is still over .5 or 50%. This means over HALF or 62% of Assets are used for Debt.
Leverage: Debt-to-Equity Ratio
The Debt-to-Equity Ratio (D/E) is a financial ratio showing the amount of Stockholders’ Equity and Debt used to finance a company’s Assets.
The interest expense of a business increases with a rise in the Debt of the company for financing. To gauge solvency in the face of Debt, a business uses Debt and Equity in a suitable proportion. The Debt/Equity Ratio is a significant measure of solvency since a high degree of Debt in the capital structure may make it difficult for the company to meet interest charges and principal payments at maturity.
With a high Debt position comes the risk of running out of Cash, less financial flexibility, and a greater difficulty in obtaining funds.
The Debt/Equity ratio is:
Total Liabilities / Total Equity = Debt-to-Equity Ratio
For Learning Company, the Debt/Equity ratio in 2014 was
$135,400 / $86,000 = 1.60
In 2013, it was 1.67. It is almost a constant ratio. A desirable Debt/Equity ratio depends on many factors like the rates of other companies in the industry and the access to further loans and Debt financing, among others.
Leverage: Times Interest Earned Ratio
The Times Interest Earned Ratio is Operating Income divided by Interest Expense. It is a measure of the safety margin a company has with the interest payments that it must make to its creditors. The Times Interest Earned Ratio reflects the number of times Before Tax Earnings cover Interest Expense.
The Times Interest Earned Ratio is:
Operating Income (also known as Operating Income Before Interest Expense and Taxes) divided by Interest Expense = Times Interest Earned Ratio
In 2014, Times Interest Earned was
$18,000 / $2,000 = 9
Meaning the interest of The Learning Company was covered 9 times. But, in 2013 it was covered 11 times ($22,000/$2000 = 11). The decline in the coverage is a negative indicator since fewer earnings are available to meet interest charges. A low times interest earned ratio indicates that even a small decrease in earnings may lead the company into financial straits since they will not be able to make the interest payments on their Debt.
Ratio Analysis: Profitability Ratios
For the purposes of illustration of financial ratios, let’s use a standard Balance Sheet:
And a standard Income Statement:
Profitability Ratios
Profitability ratios measure how much operating income or net income an organization is able to generate relative to its Assets, Owners’ Equity, and Sales.
Common Profitability Ratios include Profit Margin, Return on Assets, and Return on Equity. Investors will be reluctant to associate themselves with an entity with poor earning potential. Creditors will also steer clear of companies with deficient profitability since the amounts owed to the creditors may not be paid.
Let us have a close look at some major ratios that measure operating results.
The numerator (top number) used in these examples is always the net income after taxes.
Profitability: Gross Profit Margin
In essence, Gross Profit Margin is the gap between the Net Sales and Cost of Goods divided by the Net Sales. It reveals the percentage of each dollar left over after the business has paid for its goods. The higher the Gross Profit earned, the better.
First, calculate the Gross Profit
Net Sales – Cost of Goods Sold = Gross Profit.
For 2014, the Gross Profit was
80,000 – 50,000 = 30,000
To calculate the Gross Profit Margin,
Gross Profit / Net Sales = Gross Profit Margin
The Gross Profit margin for the Learning Company in 2012 is
30,000/80,000 = .38
In 2013, the Gross Profit Margin was 0.41. So, the business is earning less Gross Profit on each Sales dollar than just a year before. This can have a significant impact on the company in the future should it need to borrow financing.
Profitability: Profit Margin
The Profit Margin, computed by dividing Net Income by Net Sales, shows the percentage profits earned by the company. It is based upon data obtained from the Income Statement. The higher the profit margin, the better the cost controls within the company and the higher the return on every dollar of revenue. This shows that the profitability generated from revenue and so it is an important measure of operating performance.
Profit Margin is:
Net Income / Net Sales = Profit Margin
In 2014, the Learning Company’s profit margin is:
9,600 / 80,000 = 0.12
In 2013, the ratio was also 0.12 (12,000/ 102,000). So, the earning power of the business remained the same for both years.
Profitability: Return on Investment
Return on Investment (ROI) is a key, but rough, measure of performance. It shows the extent to which earnings are achieved on the investment made in the business, though in a somewhat distorted way; because it emphasizes the worth of the business for either valuation for resale or to attract more investors and not necessarily the effective worth of the business. Two ratios test the return on investment:
- Return on Total Assets (ROA) – Evaluates how much profit a company is able to keep for every dollar it makes i.e. if the company is using money wisely.
- Return on Equity (ROE) – Evaluates how effective an investment into a company is for its owners or stockholders.
The Return on Total Assets (ROA) depicts the efficiency with which management has used resources to generate income. In general, the higher the ROA the better because it means a company is making more money on less investments.
ROA is:
Net Income / Total Assets = Return on Assets (ROA)
For the Learning Company in 2014, the ROA is:
$9,600/$220,000 = 0.0435 or 4.4%
In 2013, the return was 0.0623 or 6.2%. So, productivity of Assets has decreased. The Learning Company, with a low return on Assets, is probably not using its Assets productively—a key managerial failing and impacting the potential valuation of the company for acquisition.
Return on Equity (ROE), determines the profitability or effectiveness of the use of the investment has had in making a company profitable. With ROE the higher the better to show the worthiness of the investment.
ROE is:
Net Income / Average Equity = Return on Equity
(Calculate Average Equity by adding the Beginning Total Equity
and the Ending Total Equity and then dividing this sum by 2).
In 2014, the ROE for the Learning Company was:
First, calculate the Average Equity:
($75,000 + $84,600) / 2 = $79,800
Then calculate the ROE:
$9600 / $79,800 = 0.123 or 12%
Depending on the status of the market and in comparison to peers, a business owner can surmise if this is enough to earn on the investment.
Ratio Analysis: Market Value and Dividend Ratios
For the purposes of illustration of financial ratios, let’s use a standard Balance Sheet:
And a standard Income Statement:
Market Value Ratios
Market Value Ratios are the final group of ratios we will examine. These ratios focus on the relation of firm’s Stock Price to its Earnings per Share. They also include dividend-related ratios (ratios that shed light on that earnings that go to the Equity holders.)
Let us have a close look at the ratios in this final category by first calculating the Earnings per Share
Market Value: Earnings per Share
Earnings per Share (EPS) is the amount of earnings per each outstanding share of a company’s stock. The calculation of EPS tells you how much money stockholders would receive if the company decided to distribute all the net earnings for the period.
In the United States, the Financial Accounting Standards Board (FASB) requires companies’ Income Statements to report EPS. EPS indicates the amount of earnings for each common share held. When preferred stock is included in the capital structure, net income must be reduced by the preferred dividends to determine the amount applicable to common stock.
When preferred stock does not exist, as is the case with the Learning Company, Earnings per Share is equal to:
Net Income / the number of common shares outstanding = Earnings per Share (EPS)
The 2014 Earnings per Share is:
$9600 / 45,000 = $2.13
In 2013, earnings per share was $2.67. The decline in earnings per share should be of concern to investors.
Almost all the Learning Company’s Profitability Ratios have declined in 2014 relative to 2013. This is a negative sign.
Market Value: Price/Earnings
Price/Earnings (P/E) ratio is equal to the market price per share divided by the earnings per share.
Let us assume that the market price per share of the Learning Company stock was $20 on December 31, 2014, and $22 on December 31, 2013.
So, the P/E ratio in 2014 is
Market Price per Share / Earnings per Share =
$20 / $2.13 = $9.39
The ratio in 2013 was $8.24. The rise in the P/E indicates that the market has a favorable opinion of the company.
Market Value: Book Value per Share
Book Value per Share is the value of a company if it were to liquidate immediately by selling all its Assets and pay off all its Liabilities. The Book Value is what would remain and this is divided by number of shares outstanding to determine Book Value per Share.
To calculate the Learning Company’s Book Value per Share in 2014:
Net Assets equals Total Assets – Intangible Assets (since Intangible Assets are difficult to appraise.) For the Learning Company, Net Assets = Total Assets since the company does not have Intangible Assets:
Total Assets – Intangible Assets = Net Assets
$220,000 – 0 = $220,000
Then calculate the Book Value:
Net Assets – Total Liabilities = Book Value
$220,000 – $135,400 = 84,600
Then, calculate the Book Value per Share (no preferred shares to consider in this example)
Book Value / Shares Outstanding =
$84,600 /45000 = $1.88
The book value per share in 2013 was $1.667 (75,000/45000) and is considerably lower than the Current market price of $20.
This means the Learning Company’s stock is favorably regarded by investors, because its market price exceeds book value.
Dividend Ratios
Many stockholders have invested in a company’s shares primarily (or at least in part) because they are interested in receiving dividends. For stockholders, two pertinent ratios are:
Dividend Yield – the annual amount of dividends paid divided by the average market price per share.
Dividend Payout Ratio – annual dividends divided by earnings per share.
In 2014 for the Learning company, let’s assume, the annual dividend is $2.00 per share (paid quarterly at $.50 (50 cents per share) = $2 per year
The average Market Price per Share was $20 and the Earnings per Share was $2.13.
Meaning, the Dividend Yield is
Annual Dividend /Market Price =
$2/$20 = .1 or 10%
And the Dividend Payout Ratio =
Annual Dividend / Earnings per Share
$2/$2.13 = .94 or 94%
While a 10% yield is strong, it is only being obtained by a 94% payout of earnings which means the company is not retaining any earnings for future growth and is instead paying far too much in dividends or not making enough to support this current payout.
Likewise in 2013, the Dividend Yield was 11% ($2/$22) and the Dividend Payout Ratio was 75% ($2/$2.67).
The change in yield and payout is, of course, unattractive to stockholders which means the company is at risk of losing its investors.