The Balance Sheet for Financial

Ratio Analysis

XYZ, Inc. Balance Sheet (in millions of $)

Current Assets 2020 2021

Cash 84 98

Accounts Receivable 165 188

Inventoryy 393 422

Total Current Assets 642 708

Current Liabilities

Accounts Payable 312 344

Notes Payable (<1 Year) 231 196

Total Current Liabilities 543 540

Long-Term Debt 531 457

Total Liabilities 1,074 997

Owner's Equity 500 550

Retained Earnings 1,799 2,041

Total Owner's Equity 2,299 2.591

Total Liabilities and Equity 3,373 3,588

Here is the balance sheet we are going to use for our financial ratio
tutorial. You will notice there are two years of data for this company so
we can do a time-series (or trend) analysis and see how the firm is
doing across time.
The Income Statement for
Financial Ratio Analysis

XYZ, Inc. Income Statements (in millions of $)

2020 2021

Sales 2,311 2,872

Cost of Goods Sold 1,344 1,685

Gross Profit 967 1,187

Depreciation 691 785

Earnings Before Interest & Taxes 276 402

Interest 141 120

Earnings Before Taxes 135 282

Net Income (Profit) 89.1 186.1

Here is the complete income statement for the firm for which we are
doing financial ratio analysis. We are doing two years of financial ratio
analysis for the firm so we can compare them.

Note
Refer back to the income statement and balance sheet as you work
through the tutorial.

Analyzing the Liquidity Ratios

The first ratios to use to start getting a financial picture of your firm
measure your liquidity, or your ability to convert your current assets too
cash quickly. They are two of the 13 ratios. Let's look at the current
ratio and the guick (acid-test) ratio.
The Current Ratio
The current ratio measures how many times you can cover your current
liabilities. The quick ratio measures how many times you can cover your
current liabilities without selling any inventory and so is a more
stringent measure ofliquidity.

Remember that we are doing a time series analysis, so we will be

calculating the ratios for each year.

Current Ratio: For 2020, take the Total Current Assets and divide them
by the Total Current Liabilities. You will have: Current Ratio = 642/543
1.18X. This meansthatthe company can pay for its current liabilities
1.18 times over. Practice calculating the current ratio for 2021.

Your answer for 2021 should be 1.31X. A quick analysis of the current
ratio will tell you that the company's liquidity has gotten just a little bit
better between 2020 and 2021 since it rose from 1.18X to 1.31X.

The Quick Ratio

Quick Ratio: In order to calculatte the quick ratio, take the Total Current
Ratio for 2020 and subtract out Inventory. Divide the result by Total
Current Liabilities. You will have: Quick Ratio = (642-393)/543 = 0.46X.

For 2021, the answer is 0.52X.

Like the current ratio, the quick ratio is rising and is a little better in
2021 than in 2020. The firm's liquidity is getting a little better. The
problem for this company, however, is that they have to sell inventory
in order to pay their short-term liabilities and that is not a good position
for any firm to be in. This is true in both 2020 and 2021.

This firm has two sources of current liabilities: accounts payable and
notes payable. They have bills that they owe to their suppliers
(accounts payable) plus they apparently have a bank loan or a loan
from some alternative source of financing. We don't know how often
they have to make a payment on the note.
Receivables Turnover
Receivables Turnover = Credit Sales/Accounts Receivable = X
so:

Receivables Turnover 2,311/165 14X

A receivables turnover of 14X in 2020 means that all accounts

receivable are cleaned up (paid off) 14 times during the 2020 year. For
2021, the receivables turnover is 15.28X. Look at 2020 and 2021 Sales
in The Income Statement and Accounts Receivable in The Balance
Sheet.

The receivables turnover is rising from 2020 to 2021. We can't tell if

this is good or bad. We would really need to know what type of
industry this firm is in and get some industry data to compare to.

Customers paying off receivables is, of course, good. But, if the

receivables turnover is way above the industry's, then the firm's credit
policy may be too restrictive, 2]

Average Collection Period

Averagecollection period is also about accounts receivable. It is the
number of days, on average, that it takes a firm's customers to pay their
credit accounts. Together with receivables turnover, average collection
helps the firm develop its credit and collections policy.

Average Collection Period Accounts Receivable/Average Daily

Credit Sales*

.To arrive at average daily credit sales, take credit sales and divide
by 360

For 2020:

Average Collection Period $165/2311/360 =$165/6.42 25.7

days
In 2021, the average collection period is 23.5 days

From 2020 to 2021, the average collection period is dropping. In other

words, customers are paying their bills more quickly. Compare that to
the receivables turnover ratio. Receivables turnover is rising and the
average collection period is falling.

This makes sense because customers are paying their bills faster. The
company needs to compare these two ratios to industry averages. In
addition, the company should take a look at its credit and collections
policy to be sure they are not too restrictive. Take a look at the image
above and you can see where the numbers came from on the balance
sheets and income statements.
Inventory, Fixed Assets, Total
Assets

XYZ, Inc. Condensed Balance Sheet (in millions of

$)
Current Assets
2020 2021

Cash 34 98

Accounts receivable
165 188

Inventory 393 422

Total Current Assets

642 708

Long-Term Assets

Net Plant and Equipment 2,731 2,880

Total Assets
3.373 3,588

Sales
2,311 2.872

Along with the accounts receivable ratios that we analyzed above, we

also have to analyze how efficiently we generate sales with our other
assets: inventory, plant and equipment, and our total asset base.

Inventory Turnover Ratio

The inventory turnover ratio is one of the most
important ratios a
business owner can calculate and analyze. If your business sells
products as opposed to services, then inventory is an important part of
your equation for success.

InventoryTurnover = Sales/lInventory:

If your
inventory turnover is rising, that means you are selling your
products faster. If it is falling. you are in danger of holding obsolete
inventory. A business owner has to find the optimal inventory turnover
ratio where the ratio is not too high and there are no stockouts or too
low where there is obsolete money. Both are costly to the firm.

For this company, their inventory turnover ratio for 2020 is:

Inventory Turnover Ratio = Sales//nventory = 2311/393 5.9X

This means that this company completely sells and replaces its
inventory 5.9 times every year. In 2021, the inventory turnover ratio is
6.8X. The firm's inventory turnover is rising. This is good in that they
are selling more products. The business owner should compare the
inventory turnover with the inventory turnover ratio with other firms in
the same industry.5
Fixed Asset Turnover
The fixed asset turnover ratio analyzes how well a business uses its
plant and equipment to generate sales. A business firm does not want
to have either too little or too much plant and equipment. For this firm
for 2020:

Fixed Asset Turnover =Sales/Fixed Assets = 2311/2731 = 0.85X

For 2021, the fixed asset turnover is 1.00. The fixed asset turnover
ratio is dragging down this company. They are not using their plant and
equipment efficiently to generate sales as, in both years, fixed asset
turnover is very low.4

Total Asset Turnover

The total asset turnover ratio sums up all the other asset management
ratios. If there are problems with any of the other total assets, it will
show up here, in the total asset turnover ratio.4

Total Asset Turnover = Sales/Total Asset Turnover = Sales/Total Assets

2311/3373 = 0.69X for 2020. For 2021, the total asset turnover is
0.80. The total asset turnover ratio is somewhat concerning since it
was not even 1X for either year. l
This means that it was not very efficient. In other words, the total asset
base was not very efficient in generating sales for this firm in 2020 or
2021. Why?

It seems to me that most of the problem lies in the firm's fixed assets.
They have too much plant and equipment for their level of sales. They
either need to find a way to increase their sales or sell off some of their
plant and equipment. The fixed asset turnover ratio is dragging down
the total asset turnover ratio and the firm's asset management in
general

Analyzing the Debt Management

Ratios
There are three debt management ratios that helpa business owner
evaluate the company in light of its asset base and earning power.
Those ratios are the debt-to-asset ratio, the times interest earned ratio,
and the fixed charge coverage ratios. Other debt management ratios
exist, but these help give business owners the first look at the debt
position of the company and the prudence of that debt position.
Debt-to-Asset Ratio
The first debt ratio that is important for the business owner to
understand is the debt-to-asset ratio; in other words, how much of the
total asset base of the firm is financed using debt financing. For
example. the debt-to-asset ratio for 2020 is:

Total Liabilities/Total Assets = $1074/3373 = 31.8%. This means

that 31.8% of the firm's assets are financed with debt. In 2021, the
debt ratio is 27.8%. In 2021, the business is using more equity
financing than debt financing to operate the company.

Note
We don't know if this is good or bad since we do not know the
debt-to-asset ratio for firms in this company's industry. However,
we do know that the company has a problem with its fixed asset
ratio which may be affecting the debt-to-asset ratio.

Times Interest Earned Ratio

The times interest earned ratio tells a company how many times over a
firm can pay the interest that it owes. Usually. the more times a firm
can pay its interest expense the better. The times interest earned ratio
for this firm for 2020 is:

Times Interest Earned = Earnings Before Interest and Taxes/Interest

= 276/141 = 1.96X

.For 2021, the times interest earned ratio is 3.35

The times interest earned ratio is very low in 2020 but better in 2021
This is because the debt-to-asset ratio dropped in 2021.15)

Fixed Charge Coverage

The fixed charge coverage ratio is very helpful for any company that
has any fixed expenses they have to pay. One fixed charge (expense) is
interest payments on debt, but that is covered by the times interest
earned ratio.

Another fixed charge would be lease payments if the company leases

any equipment, a building, land, or anything of that nature. Larger
companies have other fixed charges which can be taken into account.

Fixed charge coverage = Earnings Before Fixed Charges and

Taxes/Fixed Charges =. _x16

In both 2020 and 2021 for the company in our example, its only frixed
charge is interest payments. So, the fixed charge coverage ratio and the
times interest earned ratio would be exactly the same for each year for
each ratio.
 Analyzing the Profitability Ratios
The last group of financial ratios that business owners usually tackle
are the profitabilityratios as they are the summary ratios of the 13 ratio
group. They tell the business firm how they are doing on cost control,
efficient use of assets, and debt management, which are three crucial
areas of the business.

Net Profit Margin

The net profit margin measures how much each dollar of sales
contributes to profit and how much is used to pay expenses. For
example, if a company has a net profit margin of 5%, this means that 5
cents of every sales dollar it takes in goes to profit and 95 cents goes
to expenses. For 2020, here is XYZ, Incd's net profit margin:

Net Profit Margin = Net Income/Sales Revenue = 89.1/2311 = 3.9%

For 2021, the net profit margin is 6.5%, so there was quite an increase
in their net profit margin. You can see that their sales took quite a jump
but their cost of goods sold rose. It is the best of both worlds when
sales rise and costs fall. Bear in mind, the company can still have
problems even if this is the case.

Return on Assets
The return on assets ratio, also called return oninvestment, relates to
the firm's asset base and what kind of return they are getting on their
investment in their assets. Look at the total asset turnover ratio and the
return on asset ratio together. If total asset turnover is low, the return
on assets is going to be low because the company is not efficiently
using its assets.

Another way to look at the return on assets is in the context of the

Dupont method of financial analysis. This method of analysis shows
you how to look at the return on assets in the context of both the net
profit margin and the total asset turnover ratio.

To calculate the Return on Assets ratio for XYZ, Inc. for 2020, here's
the formula:

Return on Assets = Net Income/Total Assets = 2.6% 18)

For 2021, the ROA is 5.2%. The increased return on assets in 2021
reflects the increased sales and much higher net income for that year.
Return on Equity
The return on equity ratio is the one of most interest to the
shareholders or investors in the firm. This ratio tells the business owner
and the investors how much income per dollar of their investment the
business is earning. This ratio can also be analyzed by using the
Dupont method of financial ratio analysis. The company's return on
equity for 2020 was:

Return on Equity = Net Income/Shareholder's Equity = 3.9%

For 2021, the return on equity was 7.2%. One reason for the increased
return on equity was the increase in net income. When analyzing the
return on equity ratio, the business owner also has to take into

consideration how much of the firm is financed using debt and how
much of the firm is financed using equity.

Financial Ratio Analysis of XYZ

Corporation
Summary of Financial Ratios for XYC, Inc.

Ratio 2020 2021

Liquidity Ratios

Current Ratio 1.18 1.31

Quick Ratio 0.46 0.52

Asset Management Ratios

Receivables Turnover 14 15.2

Average Collection Period 25.7 days 23.5 days

Inventory Turnover Ratio 5.9 6.8

Fixed Asset Turnover Ratio 0.85

Total Asset Turnover Ratio 0.69 0.80

Debt Management Ratios

Debt-to-Asset Ratio 31.8 27.8

Times Interest Earned Ratio 1.96 3.35

Fixed Charge Coverage Ratio

1.96 3.35

Profitability Ratios

Net Profit Margin 3.9 6.5

Return on Assets 2.6 5.2

Return on Equity 3.9 7.2

 Now we have a summary of all 13financial ratios for XYZ Corporation.
The first thing that jumps out is the low liquidity of the company. We
can look at the current and quick ratios for 2020 and 2021 and see that
the liquidity is slightly increasing between 2020 and 2021, but it is still
very low.

By looking at the quick ratio for both years, we can see that this
company has to sell inventory in order to pay off short-term debt. The

company does have short-term debt accounts payable and notes

payable, and we don't know when the notes payable will come due.

Let's move on to the asset management ratios. We can see that the
firm's credit and collections policies might be a little restrictive by
looking at the high receivable turnover and low average collection
period. Customers must pay this company rapidly-perhaps too rapicly.
There is nothing particularly remarkable about the inventory turnover
ratio, but the fixed asset turnover ratio is remarkable.

The fixed asset turnover ratio measures the company's ability to

generate sales from its fixed assets or plant and equipment. This ratio
is very low for both 2020 and 2021. This means that XYZ has a lot of
plant and equipment that is unproductive.

It is not being used efficiently to generate sales for the company. In

addition, the company has to service the plant and equipment, pay for
breakdowns, and perhaps pay interest on loans to buy it through long-
term debt.

t seems that a very low fixed asset turnover ratio might be a major
source of problems for XYZ. The company should sell some of this
unproductive plant and equipment, keeping only what is absolutely
necessary to produce their product.

The low fixed asset turnover ratio is dragging down total asset
turnover. If you follow this analysis on through. you will see that it is
also substantially lowering this firm's return on assets profitability
ratio.

With this firm, it is hard to analyze the company's debt management

ratios without industry data. We don't know if XYZ is a manufacturing
firm or a different type of firm.

As a result, analyzing the debt-to-asset ratio is difficult. What we can

see, however, is that the company is financed more with shareholder
funds (equity) than it is with debt as the debt-to-asset ratio for both
years is under 50% and dropping.

This fact means that the return on equity profitability ratio will be
lower thanif the firm was financed more with debt than with equity.
On the other hand, the risk of bankruptcy will also be lower.

Unfortunately, you can see from the times interest earned ratio that the
company does not have enough liquidity to be comfortable servicing its
debt. The company's costs are high and liquidity is low. Fortunately, the
company's net profit margin is increasing because their sales are
increasing.

Hopefully. this is a trend that will continue. Return on Assets is

impacted negatively due to the low fixed asset turnover ratio and, to
some extent, by the receivables ratios. Return on Equity is increasing
from 2020 to 2021, which will make investors happy.

As you can see, it is possible to do a cursory financial ratio analysis of a

business firm with only 13 financial ratios, even though ratio analysis
has inherent limitations.