Chapter 13: Ratio Analysis

Ratio Analysis: Definition and Application Ratio Analysis is a technique used to assess the financial health of a company by analyzing relationships between different financial statement items. Ratios help identify trends, strengths, weaknesses, and potential risks in a company’s operations. They are particularly useful for comparing a company’s performance over time, with its competitors, or against industry benchmarks. How Ratios Work A ratio is simply a comparison between two numbers, showing their relationship. It can be expressed as a proportion (2:1), a percentage (200%), or a multiple (2.0 times). Ratios simplify complex data, allowing stakeholders to interpret financial statements more effectively. To be meaningful, a ratio must relate two logically connected financial elements. For example, comparing cost of goods sold to net sales is relevant because it shows how much of sales is consumed by the cost of producing or purchasing goods. Conversely, comparing unrelated items like freight costs to patents would not yield useful insights. Key Categories of Financial Ratios Financial ratios are categorized into four key areas that cover different aspects of financial performance: 1. Liquidity and Efficiency Ratios: o These assess a company’s ability to meet short-term obligations and how efficiently it uses its resources. o Common Ratios:  Current Ratio: Measures the ability to cover short-term liabilities with short-term assets. Current Ratio=Current AssetsCurrent Liabilities  A higher ratio suggests better liquidity, with 2:1 often considered a safe benchmark.  Acid-Test (Quick) Ratio: Focuses on the most liquid assets (cash, receivables, and short-term investments) to assess immediate liquidity. AcidTest Ratio=Quick AssetsCurrent Liabilities  A ratio of 1:1 or higher is generally considered acceptable.  Accounts Receivable Turnover: Indicates how often a company collects its receivables in a period. Accounts Receivable Turnover=Net SalesAverage Accounts Re ceivable  A higher turnover means faster collection of receivables. Inventory Turnover: Measures how quickly a company sells its inventory. Inventory Turnover=Cost of Goods SoldAverage Inventory  Higher turnover is generally favorable, indicating efficient inventory management. 2. Solvency Ratios: o Solvency ratios evaluate a company’s ability to meet its long-term obligations and ensure financial stability. o Common Ratios:  Debt Ratio: Shows the proportion of assets financed by debt. Debt Ratio=Total LiabilitiesTotal Assets  Lower ratios suggest less risk, while higher ratios indicate more reliance on debt.  Debt-to-Equity Ratio: Compares a company’s debt to its equity. Debt-to-Equity Ratio=Total LiabilitiesTotal Equity  A higher ratio implies greater financial leverage and risk.  Times Interest Earned (Interest Coverage Ratio): Measures how many times a company can cover its interest payments with its earnings. Times Interest Earned=Income Before Interest and Taxes (EBI T)Interest Expense  A higher ratio indicates more safety for creditors. 3. Profitability Ratios: o These ratios measure a company’s ability to generate earnings relative to sales, assets, and equity. o Common Ratios:  Gross Margin Ratio: Shows the percentage of sales revenue remaining after covering the cost of goods sold. Gross Margin Ratio=Gross ProfitNet Sales  A higher gross margin suggests better control over production costs.  Profit Margin: Indicates the portion of each sales dollar that results in net income. Profit Margin=Net IncomeNet Sales  Higher profit margins indicate better profitability.  Return on Assets (ROA): Measures how effectively a company uses its assets to generate profit. ROA=Net IncomeAverage Total Assets  A higher ROA reflects more efficient asset use.  Return on Equity (ROE): Assesses a company’s ability to generate profit from shareholders' investments. ROE=Net IncomeAverage Equity  Higher ROE is favorable as it indicates more efficient use of equity. 4. Market Prospects Ratios:  o o These are used to assess a company’s market performance and investor expectations. Common Ratios:  Price-Earnings (P/E) Ratio: Compares a company’s share price to its earnings per share. P/E Ratio=Market Price per ShareEarnings per Share (EPS)  A high P/E ratio suggests high growth expectations.  Dividend Yield: Indicates the percentage of a stock’s market price paid to shareholders as dividends. Dividend Yield=Annual Cash Dividends per ShareMarket Price per Share  Higher yields may attract income-focused investors. Applying Ratio Analysis 1. Intracompany Analysis: o Ratios are compared to the company’s historical ratios to identify trends. For example, comparing Apple’s profit margin over the past five years helps determine if profitability is improving or declining. 2. Competitor Analysis: o Comparing a company’s ratios with those of its direct competitors can reveal strengths and weaknesses. For example, comparing the current ratio of Apple to that of Samsung and Google helps assess Apple’s liquidity relative to its peers. 3. Industry Analysis: o Ratios can be benchmarked against industry averages to evaluate whether a company is performing above or below industry norms. For example, an inventory turnover ratio significantly higher than the industry average suggests better inventory management. 4. Guideline Comparison: o Ratios are evaluated against general standards or rules of thumb, such as a current ratio of 2:1 being considered safe for liquidity. Example of Ratio Analysis Application • • • Apple’s Current Ratio: 1.54 o This ratio is lower than Google’s (3.37) and Samsung’s (2.84) but above the 1.5:1 threshold often considered safe. It suggests that Apple has enough current assets to cover its short-term liabilities. Apple’s Return on Equity (ROE): 55.9% o Apple’s ROE is significantly higher than Google’s 18.1% and Samsung’s 8.4%, indicating that Apple is more efficient in generating returns for its shareholders. Debt-to-Equity Ratio: 2.74 o This ratio shows that Apple relies more on debt than equity for financing. While this can increase returns for shareholders in good times, it also presents higher risk during downturns. Summary Ratio Analysis provides valuable insights into a company’s financial condition by highlighting relationships between different financial elements. It helps identify trends, compare performance with peers, and make more informed decisions. By focusing on liquidity, efficiency, solvency, profitability, and market prospects, ratio analysis covers the critical aspects of a company’s financial health and future prospects.