{"id":3426,"date":"2015-06-23T13:51:19","date_gmt":"2015-06-23T13:51:19","guid":{"rendered":"https:\/\/courses.candelalearning.com\/masterybusiness1xngcxmaster\/?post_type=chapter&p=3426"},"modified":"2017-04-19T23:36:23","modified_gmt":"2017-04-19T23:36:23","slug":"financial-ratio-analysis","status":"publish","type":"chapter","link":"https:\/\/courses.lumenlearning.com\/clinton-wmopen-introbusiness\/chapter\/financial-ratio-analysis\/","title":{"raw":"Financial Ratio Analysis","rendered":"Financial Ratio Analysis"},"content":{"raw":"
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\r\n\r\n\"Black<\/a>\r\n\r\nFinancial\u00a0ratios allow us to look at profitability, use of assets, inventories, and other assets, liabilities, and costs associated with the finances of the business. We can also use them to learn\u00a0how quickly people pay their bills, how long it takes the company to recover its costs for new equipment, how much cash the company has\u00a0relative to its debt, and its\u00a0return (profit) on every dollar the company invests. Financial ratios also enable\u00a0a company to compare itself to other firms in the same industry and answer questions like \"Are the other dog biscuit companies doing about the same as ours?\"\r\n\r\nSometimes it's not enough to say that a company is in good or bad financial health, especially if you're trying to compare that company with another one. To make comparisons easier, it helps to assign numbers to \"health.\" The following video explains how that can be done.\r\nhttps:\/\/www.youtube.com\/watch?v=TZZFBkbC2lA&feature=youtu.be\r\n\r\nLogical relationships exist between certain accounts or items in a company\u2019s financial statements. These accounts may appear on the same statement or on two different statements. We set up the dollar amounts of the related accounts or items in fraction form called ratios.\u00a0These ratios include the following:\r\n\r\n\r\n\r\n\r\n\r\n\r\n\r\n\r\n
Ratio<\/td>\r\nUse<\/td>\r\nComponents<\/td>\r\n<\/tr>\r\n<\/thead>\r\n
Liquidity ratio<\/td>\r\nindicate a company's short-term debt-paying ability<\/td>\r\ncurrent (or working capital) ratio<\/strong>; acid-test (quick) ratio<\/strong>; cash flow liquidity ratio; accounts receivable turnover; number of day's sales in accounts receivable; inventory turnover<\/strong>; and total assets turnover<\/td>\r\n<\/tr>\r\n
Equity (long-term solvency) ratio<\/td>\r\nshow the relationship between debt and equity financing in a company<\/td>\r\nequity (or stockholders\u2019 equity) ratio; and stockholders\u2019 equity to debt ratio<\/td>\r\n<\/tr>\r\n
Profitability test<\/td>\r\nan important measure of a company\u2019s operating success<\/td>\r\nrate of return on operating assets; net income to net sales; net income to average common stockholders\u2019 equity; cash flow margin; earnings per share of common stock; times interest earned ratio; and times preferred dividends earned ratio<\/td>\r\n<\/tr>\r\n
Market test<\/td>\r\nhelp investors and potential investors assess the relative merits of the various stocks in the marketplace<\/td>\r\nearnings yield on common stock; price-earnings ratio; dividend yield on common stock; payout ratio on common stock; dividend yield on preferred stock; and cash flow per share of common stock<\/td>\r\n<\/tr>\r\n<\/tbody>\r\n<\/table>\r\nMany of these ratios are beyond the scope of this course; however, we will examine\u00a0the ones in bold, above, which are key to\u00a0evaluating any business.\r\n

Current (or Working Capital) Ratio<\/h2>\r\nWorking capital<\/strong> is the excess of current assets over current liabilities. The ratio that relates current assets to current liabilities is the current (or working capital) ratio<\/strong><\/b>. The current ratio indicates the ability of a company to pay its current liabilities from current assets, and thus shows the strength of the company\u2019s working capital position.\r\n\r\nYou can compute the current ratio by dividing current assets by current liabilities, as follows:\r\n
[latex]\\text{Current ratio} =\\Large{\\frac{\\text{Current assets}}{\\text{Current liabilities}}}[\/latex]<\/div>\r\nThe ratio is usually stated as a number of dollars of current assets to one dollar of current liabilities (although the dollar signs usually are omitted). Thus, for Synotech in 2010, when current assets totaled USD 2,846.7 million and current liabilities totaled USD 2,285.2 million, the ratio is 1.25:1, meaning that the company has USD 1.25 of current assets for each USD 1.00 of current liabilities.\r\n\r\nThe current ratio provides a better index of a company\u2019s ability to pay current debts than does the absolute amount of working capital. To illustrate, assume that we are comparing Synotech to Company B. For this example, use the following totals for current assets and current liabilities:\r\n\r\n\r\n\r\n\r\n\r\n\r\n\r\n
\u00a0<\/strong><\/b><\/td>\r\nSynotech<\/strong><\/b><\/td>\r\nCompany B<\/strong><\/b><\/td>\r\n<\/tr>\r\n
Current assets (a)<\/td>\r\n$ 2,846.7<\/td>\r\n$120.0<\/td>\r\n<\/tr>\r\n
Current liabilities (b)<\/td>\r\n2,285.2<\/td>\r\n53.2<\/td>\r\n<\/tr>\r\n
Working capital (a \u2013 b)<\/td>\r\n$ 561.5<\/td>\r\n$ 66.8<\/td>\r\n<\/tr>\r\n
Current ratio (a\/b)<\/td>\r\n1.25:1<\/td>\r\n2.26:1<\/td>\r\n<\/tr>\r\n<\/tbody>\r\n<\/table>\r\nSynotech has eight times as much working capital as Company B. However, Company B has a superior debt-paying ability since it has USD 2.26 of current assets for each USD 1.00 of current liabilities.\r\n\r\nShort-term creditors are particularly interested in the current ratio since the conversion of inventories and accounts receivable into cash is the primary source from which the company obtains the cash to pay short-term creditors. Long-term creditors are also interested in the current ratio because a company that is unable to pay short-term debts may be forced into bankruptcy. For this reason, many bond indentures, or contracts, contain a provision requiring that the borrower maintain at least a certain minimum current ratio. A company can increase its current ratio by issuing long-term debt or capital stock or by selling noncurrent assets.\r\n\r\nA company must guard against a current ratio that is too high, especially if caused by idle cash, slow-paying customers, and\/or slow-moving inventory. Decreased net income can result when too much capital that could be used profitably elsewhere is tied up in current assets.\r\n

Acid-Test (Quick) Ratio<\/h2>\r\nThe current ratio is not the only measure of a company\u2019s short-term debt-paying ability. Another measure, called the acid-test (quick) ratio<\/strong><\/b>, is the ratio of quick assets (cash, marketable securities, and net receivables) to current liabilities. The formula for the acid-test ratio is the following:\r\n
[latex]\\text{Acid test ratio} =\\Large{\\frac{\\text{Quick assets}}{\\text{Current liabilities}}}[\/latex]<\/div>\r\nShort-term creditors are particularly interested in this ratio, which relates the pool of cash and immediate cash inflows to immediate cash outflows.\r\n\r\nThe acid-test ratios for 2010 and 2009 for Synotech follow:\r\n\r\n\r\n\r\n\r\n\r\n\r\n\r\n\r\n
\u00a0<\/strong><\/b><\/td>\r\nDecember<\/strong><\/b><\/td>\r\n31<\/strong><\/b><\/td>\r\n\u00a0<\/strong><\/b><\/td>\r\n<\/tr>\r\n
(USD millions)<\/strong><\/b><\/td>\r\n2010<\/strong><\/b><\/td>\r\n2009<\/strong><\/b><\/td>\r\nAmount of increase or (decrease)<\/strong><\/b><\/td>\r\n<\/tr>\r\n
Quick assets (a)<\/td>\r\n$1,646.6<\/td>\r\n$1,648.3<\/td>\r\n$ (1.7)<\/td>\r\n<\/tr>\r\n
Current liabilities (b)<\/td>\r\n2,285.6<\/td>\r\n2,103.8<\/td>\r\n181.8<\/td>\r\n<\/tr>\r\n
Net quick assets (a \u2013 b)<\/td>\r\n$ (639.0)<\/td>\r\n$ (455.5)<\/td>\r\n$(183.5)<\/td>\r\n<\/tr>\r\n
Acid-test ratio (a\/b)<\/td>\r\n.72:1<\/td>\r\n.78:1<\/td>\r\n<\/td>\r\n<\/tr>\r\n<\/tbody>\r\n<\/table>\r\nIn deciding whether the acid-test ratio is satisfactory, investors consider the quality of the marketable securities and receivables. An accumulation of poor-quality marketable securities or receivables, or both, could cause an acid-test ratio to appear deceptively favorable. When referring to marketable securities, poor quality means securities likely to generate losses when sold. Poor-quality receivables may be uncollectible or not collectible until long past due. The quality of receivables depends primarily on their age, which can be assessed by preparing an aging schedule or by calculating the accounts receivable turnover.\r\n

Inventory Turnover<\/h2>\r\nA company\u2019s inventory turnover ratio shows the number of times its average inventory is sold during a period. You can calculate inventory turnover<\/strong><\/b> as follows:\r\n
[latex]\\text{Inventory turnover} =\\Large{\\frac{\\text{Cost of goods sold}}{\\text{Average inventory}}}[\/latex]<\/div>\r\nWhen comparing an income statement item and a balance sheet item, we measure both in comparable dollars. Notice that we measure the numerator and denominator in cost<\/em> rather than sales dollars. \u00a0Inventory turnover relates a measure of sales volume to the average amount of goods on hand to produce this sales volume.\r\n\r\nSynotech\u2019s inventory on 2009 January 1, was USD 856.7 million. The following schedule shows that the inventory turnover decreased slightly from 5.85 times per year in 2009 to 5.76 times per year in 2010. To convert these turnover ratios to the number of days it takes the company to sell its entire stock of inventory, divide 365 by the inventory turnover. Synotech\u2019s average inventory sold in about 63 and 62 (365\/5.76 and 365\/5.85) in 2010 and 2009, respectively.\r\n\r\n\r\n\r\n\r\n\r\n\r\n\r\n\r\n\r\n\r\n\r\n
\u00a0<\/strong><\/b><\/td>\r\nDecember<\/strong><\/b><\/td>\r\n31<\/strong><\/b><\/td>\r\n\u00a0<\/strong><\/b><\/td>\r\n<\/tr>\r\n
(USD millions)<\/strong><\/b><\/td>\r\n2010<\/strong><\/b><\/td>\r\n2009<\/strong><\/b><\/td>\r\nAmount of increase or (decrease)<\/strong><\/b><\/td>\r\n<\/tr>\r\n
Cost of goods sold (a)<\/td>\r\n$5,341.3<\/td>\r\n$5,223.7<\/td>\r\n$117.6<\/td>\r\n<\/tr>\r\n
Merchandise inventory:<\/td>\r\n<\/td>\r\n<\/td>\r\n<\/td>\r\n<\/tr>\r\n
\u00a0 January 1<\/td>\r\n$929.8<\/td>\r\n$856.7<\/td>\r\n$ 73.1<\/td>\r\n<\/tr>\r\n
\u00a0 December 31<\/td>\r\n924.8<\/td>\r\n929.8<\/td>\r\n(5.0)<\/td>\r\n<\/tr>\r\n
\u00a0\u00a0\u00a0 Total (b)<\/td>\r\n$1,854.6<\/td>\r\n$1,786.5<\/td>\r\n$ 68.1<\/td>\r\n<\/tr>\r\n
Average inventory (c) (b\/2 = c)<\/td>\r\n$927.3<\/td>\r\n$893.3<\/td>\r\n<\/td>\r\n<\/tr>\r\n
Turnover of inventory (a\/c)<\/td>\r\n5.76<\/td>\r\n5.85<\/td>\r\n<\/td>\r\n<\/tr>\r\n<\/tbody>\r\n<\/table>\r\nOther things being equal, a manager who maintains the highest<\/em> inventory turnover ratio is the most efficient. Yet, other things are not always equal. For example, a company that achieves a high inventory turnover ratio by keeping extremely small inventories on hand may incur larger ordering costs, lose quantity discounts, and lose sales due to lack of adequate inventory. In attempting to earn satisfactory income, management must balance the costs of inventory storage and obsolescence and the cost of tying up funds in inventory against possible losses of sales and other costs associated with keeping too little inventory on hand.\r\n\r\nStanding alone, a single financial ratio may not be informative. Investors gain greater insight by computing and analyzing several related ratios for a company. \u00a0Financial analysis relies heavily on informed judgment. As guides to aid comparison, percentages and ratios are useful in uncovering potential strengths and weaknesses. However, the financial analyst should seek the basic causes behind changes and established trends.\r\n\r\n\r\n\r\n\r\n\r\n
Summary of Ratios<\/caption>\r\n
Liquidity Ratios<\/strong><\/b><\/td>\r\nFormula<\/strong><\/b><\/td>\r\nSignificance<\/strong><\/b><\/td>\r\n<\/tr>\r\n
Current (or working capital) ratio<\/td>\r\nCurrent assets \/ Current liabilities<\/td>\r\nTest of debt-paying ability<\/td>\r\n<\/tr>\r\n
Acid-test (quick) ratio<\/td>\r\nQuick assets (cash + marketable securities + net receivables) \/ Current liabilities<\/td>\r\nTest of immediate debt-paying ability<\/td>\r\n<\/tr>\r\n
Inventory turnover<\/td>\r\nCost of goods sold \/ Average inventory<\/td>\r\nTest of whether or not a sufficient volume of business is being generated relative to inventory<\/td>\r\n<\/tr>\r\n<\/tbody>\r\n<\/table>\r\n

Interpretation and Use of Ratios<\/h2>\r\nAnalysts must be sure that their comparisons are valid\u2014especially when the comparisons are of items for different periods or different companies. They must follow consistent accounting practices if valid interperiod comparisons are to be made.\r\n\r\nAlso, when comparing a company\u2019s ratios to industry averages provided by an external source such as Dun & Bradstreet, the analyst should calculate the company\u2019s ratios in the same manner as the reporting service. Thus, if Dun & Bradstreet uses net sales (rather than cost of goods sold) to compute inventory turnover, so should the analyst.\r\n\r\nFacts and conditions not disclosed by the financial statements may, however, affect their interpretation. A single important event may have been largely responsible for a given relationship. For example, competitors may put a new product on the market, making it necessary for the company\u00a0to reduce the selling price of a product suddenly rendered obsolete. Such an event would severely affect net sales or profitability, but ther<\/span>e might\u00a0be little chance that such an event would\u00a0happen again.\r\n\r\nAnalysts must consider general business conditions within the industry of the company under study. A corporation\u2019s downward trend in earnings, for example, is less alarming if the industry trend or the general economic trend is also downward.\r\n\r\nInvestors also need to consider the seasonal nature of some businesses. If the balance sheet date represents the seasonal peak in the volume of business, for example, the ratio of current assets to current liabilities may be much lower than if the balance sheet date is in a season of low activity.\r\n\r\nPotential investors should consider the market risk associated with the prospective investment. They can determine market risk by comparing the changes in the price of a stock in relation to the changes in the average price of all stocks.\r\n\r\nPotential investors should realize that acquiring the ability to make informed judgments is a long process and does not occur overnight. Using ratios and percentages without considering the underlying causes may lead to incorrect conclusions.\r\n\r\nEven within an industry, variations may exist. Acceptable current ratios, gross margin percentages, debt to equity ratios, and other relationships vary widely depending on unique conditions within an industry. Therefore, it is important to know the industry to make comparisons that have real meaning.\r\n

<\/b>Demonstration Problem<\/h3>\r\nThe balance sheet and supplementary data for Xerox Corporation follow:\r\n\r\n\r\n\r\n\r\n\r\n\r\n\r\n\r\n\r\n\r\n\r\n\r\n\r\n\r\n\r\n\r\n\r\n\r\n\r\n\r\n\r\n\r\n\r\n\r\n\r\n\r\n\r\n\r\n\r\n\r\n\r\n
Xerox Corporation Balance Sheet\u00a020XX December 31(USD millions)<\/caption>\r\n
\u00a0<\/strong><\/b><\/td>\r\n20XX<\/strong><\/b><\/td>\r\n<\/tr>\r\n
Assets<\/strong><\/b><\/td>\r\n<\/td>\r\n<\/tr>\r\n
Cash<\/td>\r\n$ 1,741<\/td>\r\n<\/tr>\r\n
Accounts receivable, net<\/td>\r\n2,281<\/td>\r\n<\/tr>\r\n
Finance receivables, net<\/td>\r\n5,097<\/td>\r\n<\/tr>\r\n
Inventories<\/td>\r\n1,932<\/td>\r\n<\/tr>\r\n
Deferred taxes and other current assets<\/td>\r\n1,971<\/td>\r\n<\/tr>\r\n
Total current assets<\/td>\r\n$ 13,022<\/td>\r\n<\/tr>\r\n
Finance receivables due after one year, net<\/td>\r\n7,957<\/td>\r\n<\/tr>\r\n
Land, buildings, and equipment, net<\/td>\r\n2,495<\/td>\r\n<\/tr>\r\n
Investments in affiliates, at equity<\/td>\r\n1,362<\/td>\r\n<\/tr>\r\n
Goodwill<\/td>\r\n1,578<\/td>\r\n<\/tr>\r\n
Other assets<\/td>\r\n3,061<\/td>\r\n<\/tr>\r\n
Total assets<\/td>\r\n$ 29,475<\/td>\r\n<\/tr>\r\n
Liabilities and stockholders\u2019 equity<\/strong><\/b><\/td>\r\n\u00a0<\/strong><\/b><\/td>\r\n<\/tr>\r\n
Short-term debt and current portion of long-term debt<\/td>\r\n$ 2,693<\/td>\r\n<\/tr>\r\n
Accounts payable<\/td>\r\n1,033<\/td>\r\n<\/tr>\r\n
Accrued compensation and benefit costs<\/td>\r\n662<\/td>\r\n<\/tr>\r\n
Unearned income<\/td>\r\n250<\/td>\r\n<\/tr>\r\n
Other current liabilities<\/td>\r\n1,630<\/td>\r\n<\/tr>\r\n
Total current liabilities<\/td>\r\n$ 6,268<\/td>\r\n<\/tr>\r\n
Long-term debt<\/td>\r\n15,404<\/td>\r\n<\/tr>\r\n
Liabilities for post-retirement medical benefits<\/td>\r\n1,197<\/td>\r\n<\/tr>\r\n
Deferred taxes and other liabilities<\/td>\r\n1,876<\/td>\r\n<\/tr>\r\n
Discontinued policyholders\u2019 deposits and other operations liabilities<\/td>\r\n670<\/td>\r\n<\/tr>\r\n
Deferred ESOP benefits<\/td>\r\n(221)<\/td>\r\n<\/tr>\r\n
Minorities\u2019 interests in equity of subsidiaries<\/td>\r\n141<\/td>\r\n<\/tr>\r\n
Preferred stock<\/td>\r\n647<\/td>\r\n<\/tr>\r\n
Common shareholders\u2019 equity (108.1 million)<\/td>\r\n3,493<\/td>\r\n<\/tr>\r\n
Total liabilities and shareholders\u2019 equity<\/td>\r\n$ 29,475<\/td>\r\n<\/tr>\r\n<\/tbody>\r\n<\/table>\r\n