Ratio Analysis

Ratios are useful tools of financial analysis (Marck 2014; Healy & Cohen 2000; Tracy 2012). Sometimes, ratios of significant financial data are more meaningful than the raw data themselves. They also provide an instant picture of the financial condition, operation, and profitability of a company, provided that the trends and deviations reflected by the ratios are interpreted properly.

Ratio analyses are subject to two constraints: past performance and various accounting methods. Past performance is not a sure basis for projecting the company's condition in the future. Various accounting methods employed by different companies may result in different financial figures (e.g., inventory accounting and depreciation), rendering a comparison that is less meaningful between companies in the same industry. Typically, accountants try to reconcile financial statements before conducting comparative analyses. Examples of adjustments that are frequently made include:

  • 1. Adjusting LIFO inventories to a FIFO basis (Appendix 6.E).
  • 2. Changing the write-off periods of intangible assets, such as goodwill, patents, and trademarks (Appendix 6.D).
  • 3. Adding potential contingency liabilities if lawsuits are pending (Section 6.4.5).
  • 4. Reevaluating assets to reflect current market values (Section 7.3.2, entry (4)).
  • 5. Changing debt obligations to reflect current market interest rates.
  • 6. Restating reserves or charges for bad debts, warranties, and product returns.
  • 7. Reclassifying operating leases as capital leases.

When performing ratio analyses, it is advisable to follow this set of generally recommended guidelines:

  • 1. Focus on a limited number of significant ratios.
  • 2. Collect data over a number of past periods to identify the prevalent trends.
  • 3. Present results in graphic or tabular form according to standards (e.g., industrial averages).
  • 4. Concentrate on all major variations from the standards.
  • 5. Investigate the causes of these variations by cross-checking with other ratios and raw financial data.

In the financial literature, many of the ratios defined in Section 7.4.1 are systematically collected and published for key companies in various industries by investment services companies. Sources of information on ratios and other financial measures are typically reported regularly and made available for use by the public in publications such as Value Line Investment Survey, Standard & Poor's Industrial Survey, and Moody's Investors Services. STEM professionals should develop the habit of reading and considering such reports.

Other commercial sources are accessible through the Internet. For the 500 stocks comprising Standard & Poor's index, five specific ratios—current ratio, long-term debt to capital, net income to sales, return on assets, and return on equity—are published in

Financial Accounting and Management for Engineering Managers

TABLE 7.8

XYZ Company Income Statement

2012

2013

Sales

330,000

395,000

Cost of sales

265,000

280,000

Gross profit

65,000

115,000

Selling and administrativea

95,000

88,000

Other expenses

4,000

3,500

Interest

2,000

3,000

Profit before taxes

(36,000)

20,500

Federal income tax

0

10,000

Net income (loss)b

(36,000)

10,500

223

a Includes depreciation of $15,500 in 2012 and $15,000 in 2013. b No dividends paid in 2012.

TABLE 7.9

XYZ Company Balance Sheet

2012

2013

Assets

Cash

18,500

17,000

Marketable securities

0

5,000

Accounts receivable

39,500

28,500

Inventories

98,000

113,000

Total CAs

156,000

163,500

Plant and equipment (net)

275,000

290,000

Other assets

3,000

8,000

Total assets

434,000

461,500

Liabilities

Accounts payable

34,500

18,000

Notes payable

20,000

25,000

Accrued expenses

18,500

11,500

Total CLs

73,000

54,500

Mortgage payable

20,000

30,000

Common stock

200,000

200,000

Earned surplus

141,000

177,000

Total liabilities and equities

434,000

461,500

a widely available special guide for consecutive 10-year periods (Standard and Poor's 2013).

Example 7.4

For the years 2012-2013, the financial statements of XYZ Company are given in Tables 7.8 and 7.9. Define the performance ratios of the company.

Answer 7.4

The 2012 performance ratios of XYZ Corporation are

1. Liquidity

a. Current ratio = CA/CL = 3.1

From the creditor's standpoint, this ratio should be as high as possible. On the other hand, prudent management will want to avoid the excessive buildup of idling cash or inventories (or both).

b. Quick ratio = Quick assets/CL = 0.931

A result far below 1:1 can be a warning sign.

c. Interest coverage ratio = 7.833

The EBIT of the firm could pay 7.833 times the interest and other costs associated with the long-term debts. This ratio is good.

2. Debt versus equity

a. Long-term debt to capitalization ratio = 4.44%

This debt level is prudent for firms in this industry.

b. Total debt to owners' equity = 22.4%

Total debt = CL + long-term debt.

OE = Common stock plus capital surplus plus accumulated retained earnings.

c. Total debt to total asset ratio = 18.3%

3. Activity

a. Sales to asset ratio = 0.86

b. Ending inventory to sales ratio = 28.6%

c. CGS/average inventory = 2.65 times

Average inventory = the average of ending inventory of two consecutive years (e.g., 2012 and 2013)

4. Profitability

a. Net income to owner's equity ratio = 2.8%

b. Net income-to-sales ratio = 2.66%

c. Gross margin to sales ratio = 29.1%

d. EBIT to total asset ratio = 5.1%

e. Net income to total asset ratio = 2.3%

f. EBIT to sales ratio = 5.9%

 
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