BM1904

FINANCIAL STATEMENT ANALYSIS

Ratio Analysis
Ratio analysis is one way to evaluate corporate data. Ratios involve a comparison of the different figures from
the balance sheet, income statement, and statement of cash flows. The analysis requires relating calculated
ratios against previous years, other companies, the industry the company is in, and even the economy at large.
Ratios can give a glimpse into the relationships among and between individual values that relate to a company’s
operations and link them to how a company has performed in the past, and how it might perform in the future.
The result is a potentially robust method of valuing the shares of a company (Hayes, 2019).

For example, a piece of data such as current assets, which appears on the balance sheet, cannot by itself tell
a whole lot – but when current assets are divided by current liabilities, important information about a company
can be obtained – namely, whether it has enough money to cover short-term debts. Then, this result will be
compared to one company’s assets-to-debts in the same industry to determine if one is on a more stable
financial footing than the other. This result can be compared to that figure against the industry average to see
if stock may outperform its peers (Hayes, 2019).

Different references provide categories of ratios (Brigham & Houston, 2017):

• Liquidity ratios - Give an idea of the firm’s ability to pay off debts that are maturing within a year.
• Asset management ratios - Give an idea of how efficiently the firm is using its assets.
• Debt management ratios - Give an idea of how the firm has financed its assets as well as the firm’s ability
to repay its long-term debt.
• Profitability ratios - Give an idea of how profitable the firm is operating and utilizing its assets.
• Market value ratios - Give an idea of what investors think about the firm and its prospects.

Satisfactory liquidity ratios are necessary if the firm is to continue operating. Good asset management ratios
are necessary for the firm to keep its costs low and thus its net income high. Debt management ratios indicate
how risky the firm is and how much of its operating income must be paid to bondholders rather than
stockholders. Profitability ratios combine the asset and debt management categories and show their effects on
Return on Equity (ROE). Finally, market value ratios tell us what investors think about the company and its
prospects (Brigham & Houston, 2017).

All of the ratios are important, but different ones are more important for some companies than for others. For
example, if a firm borrowed too much in the past and its debt now threatens to drive it into bankruptcy, the debt
ratios are key. Similarly, if a firm expanded too rapidly and now finds itself with excess inventory and
manufacturing capacity, the asset management ratios take center stage. The ROE is always important; but a
high ROE depends on maintaining liquidity, on efficient asset management, and on the proper use of debt.
Managers are, of course, vitally concerned with the stock price; but managers have little direct control over the
stock market’s performance, while they do have control over their firm’s ROE. So, ROE tends to be the main
focal point (Brigham & Houston, 2017).

Liquidity Ratios
Liquidity ratios help users in answering the question, “Will the firm be able to pay off its debts as they come due
and thus remain a viable organization?” If the answer is no, liquidity must be addressed (Brigham & Houston,
2017).

• Liquidity Ratios show the relationship of a firm’s cash and other current assets to its current liabilities.
• Liquid Asset is an asset that can be converted to cash quickly without having to reduce the asset’s price
very much.

Current Ratio – This is the primary liquidity ratio, which is calculated by dividing current assets by the current
liabilities. It indicates the extent to which current liabilities are covered by those assets expected to be converted
to cash in the near future.

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𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 =
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿

Current Assets – These include cash, marketable securities, accounts receivable, and inventories. If a
company is having financial difficulty, it typically begins to pay its accounts payable more slowly and to borrow
more from its bank, both of which increase current liabilities. If current liabilities are rising faster than current
assets, the current ratio will fall; and this is a sign of possible trouble (Brigham & Houston, 2017).

Quick (Acid Test) Ratio – This is the second liquidity ratio, which is calculated by deducting inventories from
current assets and then dividing the remainder by current liabilities.

𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 − 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼

𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 =
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿

Inventories are typically the least liquid of a firm’s current assets; and if sales slow down, they might not be
converted to cash as quickly as expected. Also, inventories are the assets on which losses are most likely to
occur in the event of liquidation. Therefore, the quick ratio, which measures the firm’s ability to pay off short-
term obligations without relying on the sale of inventories, is important (Brigham & Houston, 2017).

Asset Management Ratios

Asset management ratios are the second group of ratios, which measure how effectively the firm is managing
its assets. These ratios answer this question, “Does the amount of each type of asset seem reasonable, too
high, or too low in view of current and projected sales?” These ratios are important because when a company
acquires assets, it must obtain capital from banks or other sources— and capital is expensive. Therefore, if the
company has too many assets, its cost of capital will be too high, which will depress its profits. On the other
hand, if its assets are too low, profitable sales will be lost. So the company must strike a balance between too
many and too few assets, and the asset management ratios will help it strike this proper balance.

Inventory Turnover Ratio – “Turnover ratios” divide sales by some asset: Sales/Various assets. As the name
implies, these ratios show how many times the asset is “turned over” during the year. Here is the formula for
the inventory turnover ratio:
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 =
𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼

Turnover is a term that originated many years ago with the old Yankee peddler who would load up his wagon
with pots and pans, and then go off on his route to peddle his wares. The merchandise was called working
capital because it was what he sold, or “turned over,” to produce his profits, whereas his “turnover” was the
number of trips he took each year. Annual sales divided by inventory equaled turnover or trips per year. If he
made 10 trips per year, stocked 100 pots and pans, and made a gross profit of P50 per item, his annual gross
profit was (100) (P50) (10) = P50,000. If he went faster and made 20 trips per year, his gross profit doubled,
other things held constant. So, his turnover directly affected his profits (Brigham & Houston, 2017).

Days Sales Outstanding (DSO) Ratio – This is used to evaluate accounts receivable. It is also called the
average collection period and is calculated by dividing accounts receivable by the average daily sales to find
how many days’ sales are tied up in receivables. Thus, the DSO represents the average length of time the firm
must wait after making a sale before receiving cash.

𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂 (𝐷𝐷𝐷𝐷𝐷𝐷) = =
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑝𝑝𝑝𝑝𝑝𝑝 𝑑𝑑𝑑𝑑𝑑𝑑 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠/365

The DSO can be compared with the industry average, but it is also evaluated by comparing it with the company’s
credit terms. If a company’s credit policy calls for payment within 30 days, a higher DSO indicates that the
customers, on average, are not paying bills on time. It is depriving the company of funds that could be used to
reduce bank loans or some other type of costly capital. Moreover, the high average DSO indicates that if some

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customers are paying on time, quite a few must be paying very late. Late-paying customers often default, so
their receivables may end up as bad debts that can never be collected.

Fixed Assets Turnover Ratio – This is the ratio of sales to net fixed assets to measure how effectively the firm
uses its plant and equipment.
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
𝐹𝐹𝑖𝑖𝑥𝑥𝑥𝑥𝑥𝑥 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 =
𝑁𝑁𝑁𝑁𝑁𝑁 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴

Potential problems may arise when interpreting the fixed assets turnover ratio. Recall that fixed assets are
shown on the balance sheet at their historical costs less depreciation. Inflation has caused the value of many
assets that were purchased in the past to be seriously understated. Therefore, if an old firm whose fixed assets
have been depreciated is compared with a new company with similar operations that acquired its fixed assets
only recently, the old firm will probably have the higher fixed assets turnover ratio. However, this would be more
reflective of the age of the assets than of inefficiency on the part of the new firm. The accounting profession is
trying to develop procedures for making financial statements reflect current values rather than historical values,
to help make better comparisons. However, at the moment, the problem still exists; so financial analysts must
recognize this problem and deal with it judgmentally (Brigham & Houston, 2017).

Total Assets Turnover Ratio – This measures the turnover of all the firm’s assets, and it is calculated by
dividing sales by total assets.
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑒𝑒𝑟𝑟 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 =
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴

This ratio measures how efficiently a firm uses its assets to generate sales, so a higher ratio is always more
favorable. Higher turnover ratios mean the company is using its assets more efficiently. Lower ratios mean that
the company is not using its assets efficiently and most likely have management or production problems (Asset
Turnover Ratio, 2019).

Debt Management Ratios

The use of debt will increase, or “leverage up,” a firm’s ROE if the firm earns more on its assets than the interest
rate it pays on debt. However, debt exposes the firm to more risk than if it is financed only with equity (Brigham
& Houston, 2017). The debt management ratio measures how much of a company's operations comes from
debt instead of other forms of financing, such as stock or personal savings (Farlex, Inc., 2019).

Total Debt to Total Capital – This measures the percentage of the firm’s capital provided by debtholders.

𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑡𝑡𝑡𝑡 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 =
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 + 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸

Total debt includes all short-term and long-term interest-bearing debt, but it does not include operating items
such as accounts payable and accruals. Creditors prefer low debt ratios because of the lower the ratio, the
greater the cushion against creditors’ losses in the event of liquidation. Stockholders, on the other hand, may
want more leverage because it can magnify expected earnings (Brigham & Houston, 2017).

Times-Interest-Earned (TIE) Ratio – This is determined by dividing earnings before interest and taxes by the
interest charges.

𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸
𝑇𝑇𝑇𝑇𝑇𝑇 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 =
𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝐶𝐶ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎

The TIE ratio measures the extent to which operating income can decline before the firm is unable to meet its
annual interest costs. Failure to pay interest will bring legal action by the firm’s creditors and probably result in
bankruptcy. Note that earnings before interest and taxes, rather than net income, are used in the numerator.
Because interest is paid with pretax dollars, the firm’s ability to pay current interest is not affected by taxes
(Brigham & Houston, 2017).

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Profitability Ratios
Financial statements reflect events that happened in the past and also provide signs about what’s important for
the future. Profitability ratios show the combined effects of liquidity, asset management, and debt on operating
results (Brigham & Houston, 2017).

Operating Margin is calculated by dividing operating income (EBIT) by sales, gives the operating profit per
peso of sales.
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸
𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 =
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆

Profit Margin, sometimes called the net profit margin, is calculated by dividing net income by sales.

𝑁𝑁𝑁𝑁𝑁𝑁 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 =
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆

Return on Total Assets (ROA) is the ratio of net income to total assets. This is computed by dividing net
income by total assets.

𝑁𝑁𝑁𝑁𝑁𝑁 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼
𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑜𝑜𝑜𝑜 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 (𝑅𝑅𝑅𝑅𝑅𝑅) =
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴

Return on Common Equity (ROE) is the ratio of net income to common equity which measures the rate of
return on common stockholders’ investment.

𝑁𝑁𝑁𝑁𝑁𝑁 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼
𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑜𝑜𝑜𝑜 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 (𝑅𝑅𝑅𝑅𝑅𝑅) =
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸

Return on Invested Capital (ROIC) measures the total return that the company has provided for its investors.

𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 (1 − 𝑇𝑇)
𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑜𝑜𝑜𝑜 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 (𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅) =
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶

ROIC differs from ROA in two (2) ways. First, its return is based on total invested capital rather than total assets.
Second, in the numerator, it uses after-tax operating income (NOPAT) rather than net income. The key
difference is that net income subtracts the company’s after-tax interest expense and therefore represents the
total amount of income available to shareholders, while NOPAT is the amount of funds available to pay both
stockholders and debtholders (Brigham & Houston, 2017).

Basic Earning Power (BEP) Ratio is calculated by dividing operating income (EBIT) by total assets.

𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸
𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 (𝐵𝐵𝐵𝐵𝐵𝐵) =
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴

This ratio shows the raw earning power of the firm’s assets before the influence of taxes and debt, and it is
useful when comparing firms with different debt and tax situations (Brigham & Houston, 2017).

Market Value Ratios

ROE reflects the effects of all the other ratios, and it is the single best accounting measure of performance.
Investors like high ROE and high ROEs are correlated with high stock prices (Brigham & Houston, 2017). Market
value ratios relate the firm’s stock price to its earnings and book value per share.

If the liquidity, asset management, debt management, and profitability ratios all look good, and if investors think
these ratios will continue to look good in the future, the market value ratios will be high; the stock price will be
as high as can be expected; and management will be judged as having done a good job. The market value

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ratios are used in three (3) primary ways: (1) by investors when they are deciding to buy or sell a stock; (2) by
investment bankers when they are setting the share price for a new stock issue (an IPO); and (3) by firms when
they are deciding how much to offer for another firm in a potential merger (Brigham & Houston, 2017).

Price/Earnings Ratio shows how much investors are willing to pay per peso of reported profits.

𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑃𝑃 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑝𝑝𝑝𝑝𝑝𝑝 𝑠𝑠ℎ𝑎𝑎𝑎𝑎𝑎𝑎

� � 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 =
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝐸𝐸 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑝𝑝𝑝𝑝𝑝𝑝 𝑠𝑠ℎ𝑎𝑎𝑎𝑎𝑎𝑎

Market/Book (M/B) Ratio is the ratio of a stock’s market price to its book value. It gives another indication of
how investors regard the company. Companies that are well regarded by investors - which means low risk and
high growth have high M/B ratios.

𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸
𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 𝑝𝑝𝑝𝑝𝑝𝑝 𝑆𝑆ℎ𝑎𝑎𝑎𝑎𝑎𝑎 =
𝑆𝑆ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂

𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 𝑝𝑝𝑝𝑝𝑝𝑝 𝑠𝑠ℎ𝑎𝑎𝑎𝑎𝑎𝑎

𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀/ 𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 =
𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣 𝑝𝑝𝑝𝑝𝑝𝑝 𝑠𝑠ℎ𝑎𝑎𝑎𝑎𝑎𝑎

Using Ratios to Assess Performance

Although financial ratios help companies in evaluating performance, it is often hard to evaluate a company by
just looking at the ratios. For example, if a company has a current ratio of 1.2, it is hard to know if that is good
or bad unless the ratio is placed in proper perspective (Brigham & Houston, 2017).

• Comparison to Industry Average. Stock investors typically use industry averages to analyze the value of
a company before investing. When investors apply industry averages to financial ratios using a company’s
financial reports from accounting, they can ascertain a company’s profitability or possibilities for growth.
These same industry averages or ratios can benefit the small business person when he wants to measure
and benchmark his company's performance against averages for the industry as a whole (Brenner, 2019).
• Benchmarking is comparing the company with a subset of top competitors in the company’s industry.
Benchmark companies are the companies used for the comparison.
• Trend Analysis is an analysis of a firm’s financial ratios over time used to estimate the likelihood of
improvement or deterioration in its financial condition. To do a trend analysis, simply plot a ratio over time.
All the other ratios could be analyzed similarly, and such an analysis can be quite useful in gaining insights.

Uses and Limitations of Ratios

As noted, ratio analysis is used by three main groups: (1) managers, who use ratios to help analyze, control,
and improve the performance of a company; (2) credit analysts, including loan officers and bond rating analysts,
who analyze ratios to help judge a company’s ability to repay its debts; and (3) stock analysts, who are interested
in a company’s efficiency, risk, and growth prospects (Brigham & Houston, 2017).

Ratio analysis can provide useful information concerning a company’s operations and financial condition, and
it does have limitations. Some potential problems are as follows (Brigham & Houston, 2017):
1. Many firms have divisions that operate in different industries; and for such companies, it is difficult to develop
a meaningful set of industry averages. Therefore, ratio analysis is more useful for narrowly focused firms
than for multidivisional ones.
2. Most firms want to be better than average, so merely attaining average performance is not necessarily
good. As a target for high-level performance, it is best to focus on the industry leaders’ ratios. Benchmarking
helps in this regard.
3. Inflation has distorted many firms’ balance sheets; book values are often different from market values.
Market values would be more appropriate for most purposes, but we cannot generally get market value
figures because assets such as used machinery are not traded in the marketplace. Further, inflation affects

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asset values, depreciation charges, inventory costs, and thus profits. Therefore, a ratio analysis for one firm
over time or a comparative analysis of firms of different ages must be interpreted with care and judgment.
4. Seasonal factors can also distort a ratio analysis. For example, the inventory turnover ratio for a food
processor will be radically different if the balance sheet figure used for inventory is the one just before,
versus just after, the close of the canning season. This problem can be mitigated by using monthly averages
for inventory (and receivables) when calculating turnover ratios.
5. Firms can employ “window dressing” techniques to improve their financial statements. To illustrate, people
tend to think that larger hedge funds got large because their high returns attracted many investors.
6. Different accounting practices can distort comparisons. As noted earlier, inventory valuation and
depreciation methods can affect financial statements and thus distort comparisons among firms. Also, if
one firm lease much of its productive equipment, its fixed assets turnover may be artificially high because
leased assets often do not appear on the balance sheet. At the same time, the liability associated with the
lease may not appear as debt, keeping the debt ratio low, even though failure to make lease payments can
bankrupt the firm. Therefore, leasing can artificially improve both the turnover and debt ratios. The
accounting profession has taken steps to reduce this problem, but it still can cause distortions.
7. It is difficult to generalize about whether a particular ratio is “good” or “bad.” For example, a high current
ratio may indicate a strong liquidity position, which is good, but it can also indicate excessive cash, which
is bad because excess cash in the bank is a nonearning asset. Similarly, a high fixed assets turnover ratio
may indicate that the firm uses its assets efficiently, but it could also indicate that the firm is short of cash
and cannot afford to make needed fixed asset investments.
8. Firms often have some ratios that look “good” and others that look “bad,” making it difficult to tell whether
the company is, on balance, strong or weak. To deal with this problem, banks and other lending
organizations often use statistical procedures to analyze the net effects of a set of ratios and to classify
firms according to their probability of getting into financial trouble.

Ratio analysis is useful but awareness on the problems listed and making adjustments are necessary. Ratio
analysis conducted in a mechanical, unthinking manner is dangerous; but used intelligently and with good
judgment, can provide useful insights into firms’ operations (Brigham & Houston, 2017).

References
Asset Turnover Ratio. (2019). Retrieved from My Accounting Course:
https://www.myaccountingcourse.com/financial-ratios/asset-turnover-ratio
Brenner, L. (2019). What Makes Industry Averages in Accounting So Valuable to Companies? Retrieved from
Chron: https://smallbusiness.chron.com/industry-averages-accounting-valuable-companies-
25354.html
Brigham, E. F., & Houston, J. F. (2017). Fundamentals of Financial Management (Concise) (9e). New Jersey,
Boston, United States of America: Cengage Learning.
Farlex, Inc. (2019). Debt Management Ratio. Retrieved from The Free Dictionary: https://financial-
dictionary.thefreedictionary.com/debt+management+ratio
Hayes, A. (2019). Ratio Analysis Tutorial. Retrieved from Investopedia:
https://www.investopedia.com/university/ratio-analysis/
Melicher, R. W., & Norton, E. A. (2017). Introduction to Finance (Markets, Investments, and Financial
Management) (16th Edition). New Jersey, New Jersey, United States of America: John Wiley & Sons,
Inc.

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