Ratio Analysis: An Approach To Understanding Strengths and Weaknesses in A Business

Ratio Analysis
An approach to understanding
strengths and weaknesses in a
business
Ratio analysis of financial
statements is useful to
 1) managers wanting to understand
company strengths and
weaknesses, or to set goals for
improvement.
 2) company creditors wanting to
assess the risk in granting credit

to the firm.
 3) company stockholders wanting to
assess performance.
While literally hundreds of
different ratio comparisons
could be computed for a
company, it is useful to divide
ratios into several different
classes. Often only a few ratios
in each class are sufficient to
understand the major strengths
and weaknesses of the firm.
An Example Company:
The ABC Company
Balance Sheet Data: Income Statement
Data:
Debt $32,500 Sales $131,000
Equity 22,100 Op. Exp. 102,000
Total Assets $54,600 Interest exp. 15,200
Net income $ 9,660

The ROE can be calculated to
be $9,660/$22,100 = 43.7%
 But, we want to know how this was
achieved?
 A useful mathematical identity allows us
to break down the overall return on equity
as the multiplicative product of three
ratios: margin, turnover, and
leverage.
 Profitability =
(Margin) X (Turnover) X (Leverage)
This is illustrated for the ABC
Co. as follows:
 Margin = Profit/Sales = 9,660/131,000
= 7.37%
 Turnover = Sales/Assets = 1,000/54,600
= 2.40
 Leverage = Assets/Equity =
54,600/22,100 = 2.47
 Thus, ROE = 43.7% = .0737 x 2.4 x 2.47
Each of the three ratios that
make up the ROE can be
compared to industry norms.
 Suppose that the industry average

ratios for comparison are: ROE =
43.1%, with margin, turnover, &
leverage = 12.5%, 2.3, & 1.5
respectively.
We now see that the ABC
Company …
 has a lower than average profit margin.
(This points to higher than average
operating costs!)
 has about average turnover. (This means
that their total investment in assets is
average.)
 has much higher financial leverage. (This
points to higher than average riskiness!)
This is a good start to
seeing what is happening in
this company. Additional
ratio analysis can add
specifics to this general
overview.
Lets consider some of these
other, more specific ratios.
It is easiest to understand
that each ratio fits within
one of 5 general categories
of ratios:
Five categories of ratios:
 1) Short-term solvency (or liquidity) ratios.
 2) Activity (or turnover) ratios.
 3) Financial leverage (or long-term solvency)
ratios.
 4) Profitability ratios.
 5) Value ratios.
 We will examine some ratios in each class in

turn.
Short-term solvency (or
liquidity) ratios
 Liquidity refers to how much cash (or assets
that could be quickly converted to cash)
a business has on hand.
 A highly liquid business has little risk of not
being able to pay its bills on time, thus all
else the same, liquidity is a good thing!
 However, too much liquidity often hurts
profitability because liquid assets earn very
low rates of return.
Liquidity ratios:
The current ratio
 This is the most widely used liquidity
ratio
 It is defined as:
(Current assets)/(Current liabilities)
The larger this ratio, the more liquid the

business. (This assumes that current
assets can be quickly converted to cash.)
Liquidity ratios:
See text book for a

description of other liquidity
ratios
Activity (or turnover) ratios
 Turnover measures the efficiency in managing
asset investment.
 The general form of these ratios is
Sales/(Some asset or group of assets)
 When turnover is high, it means that
management generates a high volume of
sales revenue from a small investment in
assets. (There is much activity per dollar
invested in assets.) This is obviously
desirable!
The Total Asset Turnover Ratio
 Defined as:
(Sales)/(Total assets)
 The larger this ratio, the more activity

(Sales) the management is able to
generate per dollar invested in
assets.
Activity ratios:
 See text book for a description of

other activity ratios
Financial Leverage ratios (or
long-term solvency) ratios)
 These ratios measure the extent to which
a company uses debt financing
 Greater use of debt financing => greater
financial risk!
 Extensive use of debt financing (leverage)
implies risk of default on debt

payments and possible bankruptcy.
Leverage ratios:
The Debt Ratio
 Defined as:
(Total debt)/(Total assets)
 The larger this ratio, the more leveraged

the business, and the more financial
risk in the business.
Leverage ratios:
See text book for a description of other

leverage ratios
Profitability ratios
 Since profitability is of overriding
importance, these ratios are of the
highest importance.
 Strengths and weaknesses in the other
ratio categories will all impact on
profitability.
 As shown before, profitability is a
function of margin, turnover, and
leverage.
Profitability ratios:
The rate of return on equity
(ROE)
 Defined as:
(Profit)/(Equity)
 This is a key ratio for stockholders, as it

measures the overall profitability of
their investment in the business.
The profit margin
 A ratio defined as:
(Profit)/(Sales)
 The ratio measures the profit per dollar

of sales, and results from the business
selling product or services at a price
above its costs. Note: it is only
ONE COMPONENT of the overall
ROE!
Why it is usually not
appropriate to compare ratios
to companies is different
industries:
 Varying ways of doing business in
different industries means that ratio
values appropriate in one industry are
not appropriate in a different
industry.
 For example …
Consider two different retail
stores in different industries:
 A retail grocery business typically operates
with a very small profit margin, but has a
very high turnover.
 A retail jewelry store typically operates with
a low turnover, but has a high profit
margin.
 Both stores can achieve the same overall
profitability, but they do it in different
ways, as appropriate in their respective
industries.

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Ratio Analysis

assess the risk in granting credit

Net income $ 9,660

 Suppose that the industry average

 We will examine some ratios in each class in

(Current assets)/(Current liabilities)

The larger this ratio, the more liquid the

See text book for a

 The larger this ratio, the more activity

 See text book for a description of

implies risk of default on debt

 The larger this ratio, the more leveraged

See text book for a description of other

 This is a key ratio for stockholders, as it

 The ratio measures the profit per dollar

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