Ratio Analysis. Assets = Liabilities + Shareholder s Equity

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1 Ratio Analysis The purpose of a financial statement is to disclose information about the financial position of an entity to interested parties. By reporting the finances, shareholders are able to make wise investment decisions and creditors are able to make wise lending decisions. Looking at the statements at face value is not enough to determine how well a company is performing. To do a thorough analysis, various financial ratios should be calculated and studied. The preparation of these ratios is called ratio analysis and there are some very important standard ratios that are used to determine a company s financial position. The first place to start in ratio analysis is with the financial structure of the company. This is exemplified in the accounting equation: Assets = Liabilities + Shareholder s Equity What analysts look at is the amount of the claims against the company s assets owned by shareholders versus those owned by creditors. This is called the debt to equity ratio and it reveals whether a company is under or over financed. Companies don t want to be over financed as this creates imminent danger of not being able to sustain operations. The opposite though, is also true. It is not wise to have excess amounts of capital uninvested in the company through more shareholder ownership or expansion. Example: Bart s Beverages Financial Structure Assets = Liabilities + Shareholder s Equity $4,500 = $2, , 220 Debt to Equity ratio = 2,220/2,280 = 0.97 In this example the debt and equity is almost equal but the ratios themselves will vary from industry to industry and from year to year. When evaluating the ratio, it is important to view it in terms of other industry participants and competitors. The other consideration is the trend within the company, is the ratio stable or is it changing from year to year and is that change in a positive or negative direction. These points of analysis should be used for all ratios calculated. There are three main categories of ratios: solvency, operational efficiency, and trend analysis. All of these are discussed below. Solvency Ratios Solvency deals with the question, How able is the company to pay off its debts as they become due? It refers to a company s ability to pay off current liabilities (those that are due within one year) and many ratios are used in this determination.

2 Working Capital Working capital is the difference between current assets and current liabilities for a particular point in time. This difference shows the short-term solvency in a dollar amount. Working Capital = Current Assets - Current Liabilities Current Ratio This is a ratio representation of the difference between current assets and current liabilities. The ratio indicates the amount of current assets available to cover $1 of current liabilities. Current Ratio = Current Assets / Current Liabilities The Acid Test (or Quick Ratio) This is more stringent test of solvency involving only those current assets with high liquidity. Quick current assets are cash, marketable securities, and accounts receivable; inventory and prepaid assets are not included in this calculation. An acid ratio of 1:1 is typically preferable but there are always exceptions to the rule. Acid Test = Quick Current Assets / Current Liabilities Accounts Receivable Collection Period Here you are determining how many days it takes, on average, to collect on the accounts receivable. If it takes too long to covert accounts receivable to cash, then the acid test ratio is not very valid and the company is floating customer s credit inefficiently. To calculate, take the average annual accounts receivable amount [(Opening balance + Closing balance) / 2], divide that by the net credit sales, and multiply by 365 days. This gives the average time it takes to collect on accounts receivable and helps assess the effectiveness of credit and collection procedures. A/R Collection Period = (Average Accounts Receivable / Net Credit Sales) * 365 Accounts Receivable Turnover Further to the collection period, it is useful to know how often the accounts receivable turnover. This means how many times in a year the accounts receivable are converted to cash. High turnover indicates that A/R are quite liquid and low turnover indicates the opposite. A/R Turnover = Net Credit Sales / Average Accounts Receivable Days Sale of Inventory Like the accounts receivable ratios, it is wise to analyze how much of the current assets are tied up in inventory. By finding the number days sale of inventory, one can figure out how many days of sales can be made with the inventory on hand. The calculation involves finding the average annual inventory [(Opening balance + Closing balance) / 2], dividing that by the Cost of Goods Sold, and then multiplying by 365 days.

3 Days Sale of Inventory = (Average Inventory / COGS) * 365 Inventory Turnover This ratio indicates how many times during the year the inventory was sold and replaced. The importance of this ratio is exemplified by the fact that every time inventory is turned over, there is a resulting gross profit. Low turnover typically indicates poor inventory management and the risk of obsolescence while high turnover is more efficient in terms of lower inventory carrying costs and less obsolescence. The issue of customer service though, is exactly the opposite: low inventory turnover usually means customers can get their product quickly whereas high turnover is often plagued with shortages and out-ofstock scenarios. Inventory Turnover = COGS / Average Inventory Operational Efficiency Ratios Companies use their assets to earn revenue and eventually net income. To evaluate the operational efficiency of these assets, net income is used as the basis for the analysis. By using net income as the base, these calculations show how many dollars are returned to the company per contribution of a particular asset, equity, or sale. The operational efficiency ratios distinguish between net income and operational net income. Net income from operations does not include income generated from interest or expenses paid for income tax. Operational income is often referred to as Earnings before Income and Taxes and abbreviated to EBIT. Return on Total Assets This ratio measures how efficiently the assets are used as a whole. Return on Total Assets = EBIT / Total Assets* * Total assets is often averaged for the year rather than using the year-end figure alone. This accounts for fluctuations in assets levels during the course of a full year. Return on Shareholder s Equity Shareholders receive the portion of income earned after interest is paid to creditors and income taxes are paid to the government. The return on shareholder s equity ratio indicates how fit the net income is to provide a dollar return to the shareholders. Return on Shareholder s Equity = Net Income / Shareholder s Equity* * Shareholder s equity is often averaged for the year rather than using the year-end figure alone. This accounts for fluctuations in equity levels during the course of a full year. Earnings Per Share This ratio shows how much income has been earned per outstanding share. Earnings Per Share = Net Income / # of Shares Outstanding

4 Price to Earnings Ratio (P/E ratio) This is a quick method for discovering whether the market price for shares in a company is reasonable. Price to Earnings Ratio = Market Price per Share / Earnings per Share Dividend Yield This ratio indicates how large a return can be expected from an investment in the company. Dividend Yield = Dividends per Share / Market Price per Share Return on Sales This is a ratio that measures the efficiency of the sales generated. This is a common performance index that is used to compare companies within the same industry. Return on Sales = Net Income / Net Sales Sales to Fixed Assets This ratio addresses whether the sales are sufficient to justify the level of investment in assets. It established the amount of sales dollars generated for each dollar invested in fixed assets. Sales to Fixed Assets = Net Sales / Fixed Assets* * Total fixed assets is often averaged for the year rather than using the year-end figure alone. This accounts for fluctuations in fixed assets levels during the course of a full year. Trend Analysis Trend analysis is the comparison of data over different periods. Rather than looking at financial data in isolation, trend analysis allows users to see what has happened previously and whether there has been a significant change in financial performance. Trend analysis looks at percentages of different amounts that appear on the financial statements and these percentages are calculated either horizontally or vertically. Horizontal Trend Analysis With this type of analysis, the percentage change of a particular item on a financial statement is calculated. The difference is shown as both a dollar amount and a percentage change, which allows for a comparative perspective. Horizontal analysis = (Newest Balance Oldest Balance) / Oldest Balance Example: $ Change % Change Current Assets $2500 $1850 +$ %

5 Fixed Assets $18,000 $12,750 -$5,250-41% With horizontal analysis, the change is looked at both in terms of what caused the change and whether the change is positive or not. This type of scrutiny is used to spot trends in financial strength and profitability. Vertical Analysis With vertical analysis every amount on the financial statements is expressed as a percentage of some base amount. For income statements the base amount is usually Net Sales. Total Assets and Total Equity are used for each of their respective sections on the balance sheet. Another term for statements that show a vertical analysis is common size. Example: 2005 Total Sales $18, % COGS 10,250 57% Gross Profit 7,750 43% Total Expenses 4,825 27% Net Income $ 2,925 16% 2005 Current Assets $ 2,500 12% Fixed Assets 18,000 88% Total Assets $20, % Total Liabilities $ 7,250 35% Total Equity 13,250 65% Total $20, %

6 Student Worksheet Ratio Analysis 1. The ratio is low when a company is using its assets inefficiently. 2. Cost of Goods Sold / Inventory is the calculation for. 3. The formula for calculating the current ratio is. 4. Which of the following is not used in the Acid Test ratio? a. Marketable securities b. Inventory c. Accounts Receivable d. Cash 5. The return on sales formula is. 6. The financial structure of the company is represented by the ratio. 7. The ability of a company to pay off its current liabilities is referred to as its level of. 8. Which ratio is commonly used to evaluate whether a company s shares are selling at a fair value? 9. An analysis that looks at the change in financial components from one period to the next is called analysis. 10. What is the formula for calculating the earnings per share ratio? 11. Net income before deductions for interest and taxes is called income and a common abbreviation for it is. 12. ARTS, Inc has current assets of $14,000 and a current ratio of 1.25, what is the value of the current liabilities? 13. If ARTS, Inc has an acid test ratio of 0.95 and its current assets consist of cash, accounts receivable, and inventory, what is the value of the inventory? 14. What is the inventory turnover if you know that total sales of $42,000 yielded a net income of $29,500? 15. Perform a horizontal analysis on the following Income Statement: Total Sales $18,000 $16,750 COGS 10,250 9,700 Gross Profit 7,750 7,050 Total Expenses 4,825 4,500 Net Income $ 2,925 $ 2,550