FINANCIAL RATIO ANALYSIS AS A
MANAGEMENT EFFECTIVENESS INDICATOR
Robert C. Losik
Professor of Organizational Leadership
and Strategic Management
Dept of Organizational Leadership
School of Business
Southern New Hampshire University
Working Paper No. 2003-05
This is a BETA VERSION (A work in progress).
Please report all errors, omissions, and suggestions
for improvement to email@example.com
Copyright 1999 and 2003 by Robert C Losik, Bow, New Hampshire,
All rights reserved. No part of this book may be reproduced or transmitted in any form or
by any means, electronic or mechanical, including photocopying, recording, faxing,
scanner, or by any information storage and retrieval system, without permission in
writing from the author.
The following persons made major contributions to the book:
Timothy P Losik, BS, MBA, CPA, extensive experience in public
accounting and corporate finance and accounting. Made major
contributions in the areas of technical accuracy, sequencing of material,
use of correct terms, content, and metrics.
Jennifer A Losik, BS, extensive experience in small business
management, comptrollership, and web development and management.
Made major contributions in the areas of readability from the perspective
of the student, sequencing of material, content, and layout.
I also wish to acknowledge the significant contributions of the following persons who
took the time and made the effort to review this book. Their contributions have been
Dr. Burton Kaliski, Professor, SNHU
Dr. Laurence Pelletier, Professor, SNHU
Mr. Stephen B. Townes, CEO, Keystone Aviation
Mr. George D. Livingston, Jr., President and CEO, REALVEST
Dr. Martin Bradley, Associate Professor, SNHU
Dr. Charles White, Professor, SNHU
Dr. Steven Painchaud
TABLE OF CONTENTS
CHAPTER 1: SOME THOUGHTS ON RATIOS 9 - 12
CHAPTER 2: THE BALANCE SHEET, INCOME 13 - 19
STATEMENT AND THE STATEMENT OF
CHAPTER 3: LIQUIDITY RATIOS 20 - 24
The current and quick ratios.
CHAPTER 4: ACTIVITY RATIOS 25 - 31
The asset turnover ratio, the inventory turnover ratio,
and the average collection period.
CHAPTER 5: LEVERAGE OR DEBT RATIOS 32 - 38
The total debt to asset ratio, long term debt to asset ratio,
the debt to equity ratio, and the times interest earned ratio.
CHAPTER 6: PROFITABILITY RATIOS 39 - 48
The gross profit margin, the operating margin, the net
profit margin, return on equity, return on assets as a function
of both operating and net profit, return on fixed assets, return on
investment, and earnings per share.
CHAPTER 7: METRICS 49 - 56
R&D/Net sales, marketing/net sales, administrative
expenses/net sales, net sales per employee, net profit per
employee, cost of waste per employee, overtime hours as a
percent of total hours, cost of quality/net sales, sales per square
foot of floor space.
APPENDIX A: MITIGATING EXTERNAL FACTORS 57 - 58
APPENDIX B: THE CONSOLIDATED CROMWELL 59-63
COMPANY CASE STUDY WITH FINANCIAL
DATA FOR THREE YEARS
"Managers must understand accounting, but they must think and act like strategists"
This handbook was initially prepared for use by non-accounting majors in
appropriate undergraduate business courses at Southern New Hampshire University,
Manchester, New Hampshire. It was envisioned that students will use this handbook as a
ready reference and refresher for all courses in which financial ratio analysis is a part of
the learning or problem-solving process. The goal is for the students to achieve and
maintain a high level of proficiency in the use of financial ratio analysis. This will give
them a solid understanding of both the financial and management implications of
financial ratios from the perspective of a non-accounting major. It may also be of interest
to the accounting major who intends to occupy a management position and for managers,
particularly of small to medium-sized businesses.
The handbook does not purport or pretend to present an exhaustive analysis of
financial ratios. Only selected ratios are used, those that in the judgement of the author
would be the most commonly used by non-accounting majors. Students and managers
seeking additional information on ratio analysis should refer to accounting and finance
texts or appropriate accounting and finance references.
Finance and accounting are integral parts of management. In most companies of
any size, the accountants, as well as all major functions areas, are the management team.
Their advice, insights, and recommendations are both sought after and valued.
Companies that must operate in highly competitive environments cannot afford the
luxury to have the various major management functional areas operate in isolation in
their own fiefdoms and fortified "silos."
While this handbook explains some financial implications of ratios, its primary
purpose is to inform about the MANAGEMENT EFFECTIVENESS INDICATORS
OF FINANCIAL RATIOS. By management effectiveness, we mean how the financial
condition of the company, as it is interpreted through the use of financial ratios, reflects
the management, the decision-making, and the vision of the company, to include how
management plans, implements, organizes, leads, and controls.
To one degree or another, the ratios that we will discuss reflect the overall
performance of the company. They are not simply indicators of the financial health of the
company. They are not, because the financial condition of the company is the product of
everything that goes right and everything that goes wrong inside of an organization.
People, policies, processes, practices, strategies, goals, and procedures determine
financial outcomes. Many internal factors determine the financial performance of an
organization. These include, but are not limited to the organization’s:
a. Mission, long range goals, and the strategies to achieve them;
b. Short range objectives and the tactics used to the achieve them;
c. Management information and feedback systems;
d. Management philosophy; and
e. Values, which form its unique "genetic code."
Because of the above, students and managers should not look at financial
information as sterile, one-dimensional data, which conveys only one meaning. The
financial condition is in many respects the pulse and lifeblood of the organization. The
hyper-focus that some current business students have on their own majors creates in some
students' minds the notion that there is no essential connection between the major
disciplines and sub-disciplines of business. They are unaware that virtually all major
strategic and tactical decisions, as well as most routine decisions, are based on the
financial condition and performance of the organization. They are also unaware that
many human resource, management, marketing, production, service, administrative, and
information systems decisions are made based on the financial condition of the company
as it exists now, and more and more today, as it is projected to exist in the future.
Many business majors will work in organizations where "somebody else crunches
the numbers." Because of this you could also make the argument that "somebody else
interprets the numbers and makes management decisions for the organization." The job of
education, however, is to insure that the student achieves, or at least is given the
opportunity to achieve, a high level of sophistication in information processing and
understanding. We should not be in the business of graduating pieces of the puzzle, but
rather students who can solve the puzzle. A failure to understand the management and
financial implications of ratio analysis undermines the degree to which students will one
day be able to understand their own organization, competitors, suppliers, and clients. The
same is true for current managers.
In business, graduates will work and hopefully learn. In education, students must
not only learn, they must learn how to continue learning. They must learn that ratio
analysis is a means to an end that helps them to continue to learn and understand. The
ratios are not an end in themselves. They are a means to the end of effective management
decision-making and organizational leadership. This learning will then help students
make strategic and tactical recommendations for the organizations they are studying,
informed decisions about their careers, and even wiser decisions when planning and
executing their own financial plans for the future.
Business majors and contemporary managers, however, should be able to take the
analysis of financial data one step further. They should be able to:
1. Draw tentative inferences about the management
effectiveness of the company. Because the financial
performance of a company, to a greater or lesser degree,
reflects the management decisions of a company, we should
be able to make inferences about the effectiveness and the
efficiency of management. These inferences, however, must
be tentative because unusual business situations and
activities, as well as mitigating external factors, can cause
misleading interpretations of the data. For examples of
external factors beyond the control of the company, see
Appendix A. While it is beyond the scope of this book,
management's effectiveness is also measured by how well it
can anticipate and/or react to these external factors and
devise and implement strategies that will attenuate their
effect on the organization. Unusual and extraordinary
internal activities could also depress or inflate any one or all
of the profit margins. With regard to the latter, expenditures
for acquisitions, restructuring, or cyclical research and
development could dramatically impact revenues and
profits. Where these situations seem to exist, the student is
obligated to go beyond the raw financial data and examine
the footnotes and other explanations in the company's
annual report and seek other factors that may have caused
2. Identify potential or actual strengths and weaknesses,
which can be attributed to the major management
functional areas of the company. These areas include, but
are not limited to: management (strategic and human
resource), finance, marketing, production and/or delivery of
a service, and information technology systems.
3. Use the information to aid in the planning and
implementation of both short-range tactics and long
range decisions to:
a. Improve or solidify the company's financial health
and gain for the organization an advantage over its
b. Identify areas in which external factors are
impacting on the financial performance of the
The three points listed above, 1., 2., and 3., are the rationale for the writing of this
handbook. There is more to ratio analysis than calculating ratios; there is more to ratio
analysis than financial analysis. Those same financial ratios also give us insight into
management issues in strategic management, human resource management, marketing,
production, delivery of a service, and management information systems of an
SOME PROCEDURAL REMARKS
GRAPHICS: In order to highlight and differentiate certain areas in this
handbook, we will use the following graphics for emphasis:
Indicates the discussion of a topic.
Indicates the calculation of a ratio or other metric.
Indicates an example of the topic under discussion.
Indicates a tip (suggestion) about the subject matter
Indicates possible manangement implications of
the analysis of the ratio or metric(s).
TARGET RATIOS: With regard to the discussion of the ratios and the tabular
data that shows the management implications of the ratios, no specific target figures for
the ratios are shown. Why? The ideal target number for each of the ratios varies from
industry to industry, and within the industry between the size of company. Therefore,
the use of comparative industry averages for your analysis is important. It is also
important to determine if the company has specific target objectives for its own ratios.
The "management implications" tables show possible management weaknesses and
strengths in terms of whether the ratios are high (hi) or low (lo) or increasing (inc) or
decreasing (dec), without comparison to specific targets.
ABBREVIATIONS: Within the "management implications" tables,
abbreviations are used to reflect the major management functions within a company.
These include: management, which will reflect both strategic management and human
resource management, finance, which will include both finance and accounting,
marketing, production, the delivery of a service, and management information systems.
If you were constructing your own tables, you could break these areas down in finer and
more discrete categories. You could create more categories if you wanted your analysis to
be more detailed, e.g., PURCHASING = PUR, HUMAN RESOURCE MANAGEMNT =
HRM. For the sake of brevity and to facilitate the construction of tables, the following
abbreviations are used for the major management functional areas.
FUNCTIONAL AREA ABBREVIATION
INFORMATION TECHNOLOGY IT
The Importance of Ratios and Metrics
"The Bottom Line: Make sure that you understand the ratios that you are using and
why you are using them and make sure that they are appropriate for the type of
company that you are analyzing."
In an e-mail to the author, Steve Townes, former CEO and President of ASIG
(Aircraft Services International Group) and current president and CEO of Keystone
Aviation offered the following contemporary insights about how management uses
financial ratios and metrics to improve the performance of a company that operates in a
highly competitive environment:
"We use extensive metrics in managing our large, far-flung
company from a tiny headquarters team. We measure not
only the traditional financial ratios and trends, plus
comparatives on those to the industry peer group, but also
many of the operating statistics and workforce statistics that
are the leading indicators that "flag" trend lines long before
we see financial statements. We coach for better
performance using these tools as the centerpiece of weekly
operations and monthly financial budget reviews. I suggest
that most good businesses "measure everything" in this
manner; the trick is picking what you really need to
measure, then measuring properly so the information is
valid. For example, our largest manageable cost pool is
labor---over 7 million man-hours of paid, rampside, touch
labor per annum. You can imagine how many ways we
splice, and dice those man hours, comparing cities to one
another, historicals, budgets, productivity, turnover, spans
of control, and a myriad of other metrics. . . by the way,
these things were not in place when we bought ASIG, our
largest unit. By using what we call our "Key Measures
Program," we have dramatically improved operating
performance and profitability. . . yielding award-winning
Steve Townes' description of the use of financial ratio analysis and metrics should
be a wake up call to all business students, both accounting and non-accounting majors.
Managers use these data as the bases to make major decisions for their companies.
Notwithstanding this, many students simply have trouble with the term, "ratio." They
either do not fully understand it, feel uncomfortable with it, or they feel that it is an
esoteric concept that has no application or value in their lives. At best, it is something to
memorize, pass a test, and forget. Because of this, I suggest to students that they may feel
more comfortable if they think of ratios as relationships or comparisons. Ratio is a
mathematical term; relationship and comparison are analytical terms and may be more
Understanding ratios is complicated by the fact that although they are supposed to
be expressed as a fraction, they generally are not. They are not because the denominator
is always one.
For example, you will frequently see a company's current ratio expressed as 2.25,
when it is actually 2.25 to 1. In most textbooks, the denominator, 1, is dropped as
a matter of convenience. For a student or manager, who is trying to understand
the significance of ratios, there is no reinforcement that they are actually dealing
with a ratio, because nothing is being compared. Visually, 2.25 is not a ratio; therefore,
the comparison is lost. This may be particularly confusing to students who experience
difficulty with math. The notion of a comparison or relationship is reinforced when a
ratio is written as 2.25 to 1, communicating to a student that there are 2.25 dollars of
current assets for each one dollar of current liabilities.
In addition to the term, ratio, there is an aura that ratios are really the primary
concern of accounting and finance and that other business majors need only be vaguely
familiar with them. This is complicated by the fact that other business majors take
introductory accounting with accounting majors, a course that is often taught by
accountants for accountants. The primary orientation of the courses is accounting not
management decision making. Notwithstanding this, any analytical process that helps
anybody in management make better business decisions or any business student make a
more thorough analysis should be learned and used. You can magnify the importance of
this by never letting yourself forget that the primary reason that profit-making
corporations are in business is to make a profit. Better decisions coupled with a profit
orientation should keep taking you back to the centrality of understanding the
significance of analyzing financial data.
Business students are managers-in-training. The primary job of managers is to
make decisions and detect and solve problems. Decision making and problem solving are
more effective when adequate, reliable, and accurate information is available. However,
frequently information is not there for the taking. Facts and data usually are available or
at least mineable through the use of various processes. Ratio analysis is one of those
processes that helps us convert raw data and facts into information that can be analyzed.
Once analyzed, the information is transformed into knowledge. Because comprehensive
ratio analysis is one of these processes, we can conclude that it can make students and
managers better problem solvers and decision-makers.
There is generally a quandary as to what to do with a financial ratio once we
calculate it. Most accountants and managers would agree that one ratio, at one
point in time, tells us little or nothing about the actual financial condition of a company.
A minimum of four criteria should be used to gain a more complete understanding of
The first is trend analysis. Ratios should be compared over a three to five year
period to gain an understanding of the financial health and direction of the organization.
If a pro forma balance sheet and income statement are prepared to project the anticipated,
future financial condition, ratios should also be calculated for the future years in question
so that trends may be observed there also. Trend analysis helps us to understand the
financial performance of an organization over time. Keep in mind that time is relative.
The time horizon for one trend may be inappropriate to use with another trend.
The second is to compare the company's performance with other similar
companies by using industry averages. Using industry averages, we get an "idea" as to
how our performance compares with others. While this can be useful, there are
potentially severe limitations. The industry must be sufficiently populated for the industry
averages to be meaningful. In addition, many larger companies are diversified, but their
net sales are combined in one balance sheet and income statement. It would be difficult
then to compare a company that produces only breakfast cereal with a company that
produces breakfast cereal, milk, dish detergent, and vitamins. To do so would lead to
faulty, inaccurate, and inappropriate conclusions. This became less of a problem in 1999,
when new accounting practices with regard to reporting the financial activities of
strategic business units took effect. Companies will have to be more explicit when
reporting the profits of its components. There could also be instances where the
performance of companies in the industry is affected by regional and seasonal variations,
unknown to the analysts.
The third is to compare the company's actual performance with its own
target ratios. The comparison could be valid, but it could also be misleading. The
company's target ratios may be too low, making performance look unrealistically good or
vice versa. In addition, many companies, particularly smaller companies and privately
owned operations, do not establish performance ratios, making this comparison
The fourth is to check any resource that contains relevant published opinions
about the company or that has evaluated its performance. Much of this information is
available on the Internet and can be easily accessed.
If we are in a situation where industry averages are unusable and the company has
no target ratios, we may be limited to trend analysis and the research of sources that have
evaluated the company. As managers, we cannot disregard the analysis of financial data
because of the inherent limitations and potential inaccuracies. Strategically, we also
cannot afford to take the position that unless there is a guaranteed outcome, we will do
nothing. There is no "silver bullet or magic wand" that gives us absolute, accurate
information. We must learn to live with uncertainty, while trying to reduce it as much as
possible. What this all means is that even though there are limitations in the analytical
process, we still use all of these approaches and keep the limitations in mind. We use
analysis as a means to an end, and not an end in itself.
A tip about calculating ratios whether you are doing them manually, on a
calculator, or on a computer: for ease of calculation, rationalize your numbers. To
rationalize means to make the number smaller in size without changing its
inherent value or the significance of the results when we calculate the ratio.
For example, let's say that we are calculating a current ratio. The company that
we are analyzing has $1, 937, 424, 653 in current assets and $877, 435, 111
dollars in current liabilities. We could divide the current assets by the current
liabilities, using the numbers as they appear and get a result of 2.2 to 1. Or we
could simply drop off the last six digits and divide 1937 by 877 and get a result of 2.2 to
1. Even if you divided 19 by 8.7, the result would be 2.18 and that is close enough. You
can save yourself a lot of work by making the numbers more manageable, without
changing the value of the result or distorting any subsequent analysis that you may make.
Here are two important reminders as we close out chapter one:
First, it is impossible to understand the significance and value of financial ratios
unless you understand the Balance Sheet and Income statement. It is also critical that you
understand the Statement of Cash Flows as well as certain other financial facts. Why?
Many, but not all, financial ratios are calculated from information contained in the
balance sheet and income statements. Most ratios are really nothing more than
comparisons or relationships between components within the balance sheet, between
components within the income statement, or between components of the balance sheet
and the income statement. So, ratios, balance sheets, and income statements go hand in
Second, if you are doing a case analysis or any business analysis where financial
data are available, always analyze that data before you read the case or situation.
Why? You will gain many insights about the financial and management
conditions of the company prior to reading the case. Understanding the financial
and management implications of ratio analysis gives us clues about the operations and
management of the company. Therefore, Chapter Two will deal exclusively with a brief,
general review of the balance sheet, the income statement, and the statement of cash
The Balance Sheet, Income Statement,
and Statement of Cash Flows
The following is a brief discussion of the balance sheet, the income statement, and
the statement of cash flows. They will be discussed in sufficient detail so that you can
understand their primary purpose and also understand the nature of the items that you will
generally find in them. Remember, when looking at financial data, you have to look at
more than one reporting period, usually a fiscal year. It is wise to examine the financial
reports from at least three years and if possible five years ago. Reports that are older than
these are historical documents and tell us little about the current operations of the
company. This is almost always true, because the nature of the organization and the
external environment in which it must function are likely to change dramatically over a
five year period, rendering any old financial data useless for anything other than
THE BALANCE SHEET:
Regardless of your specific academic discipline, it is essential that you understand
and commit to memory the meaning and the purpose of the balance sheet, the income
statement, and the statement of cash flows. If you can't memorize, then keep using this
handout to refresh your memory.
An accountant would say that the balance sheet is a picture, "a snapshot", of the
financial condition of the company at a point in time. Cool, huh? Maybe it would make
more sense to the non-accountant if we said that the balance sheet displays in broad
financial categories, the dollar value of what we own and the dollar value of what we
owe. The "what we own" part is pretty simple. It includes all of our assets, both current
and fixed. Some books call fixed assets long-term assets; others refer to them as plant and
equipment. The key is that they are assets that would generally take a longer time to
liquidate or turn into cash. They are also the primary assets that the company uses to
manufacture its goods and products or with which it delivers or prepares its services for a
customer. The notion of liquidity underpins the asset portion of the balance sheet: current
assets are relatively easy to turn into cash; fixed assets are generally much more difficult.
The asset portion of the balance sheet does not give a detailed listing of all assets. It is not
designed to do this. It gives us the dollar value of assets, at the date of purchase, by
categories that accountants use. It does not represent the value of the asset today. We can
live with that. See Figure 1. For a detailed listing, we would consult other references in
The liability/equity portion of
the balance sheet is a little more
difficult to comprehend. It contains CROMWELL COMPANY, INC
two major categories: liabilities and
owners' and/or stockholders' equity. THE BALANCE SHEET (000)
The liability part is what we owe
others. It is broken down into current 2002
and long-term liabilities. The current
portion shows what we have to cover Cert. of Deposit (Cash Equivalent) 0
(payoff) in the near future. The long
Accounts Receivable 9000
term is exactly that, liabilities that we Other Current Assets 2950
have accumulated that are due Inventory 15000
(payable) beyond a one year period of Total current Asset 31950
time, like a five year loan on a car or a
thirty year mortgage on a house. See
Figure 1. Fixed Assets 141742
Accumulated Depreciation -14174
That's easy to understand, but Net Fixed Assets 127568
why is equity on that portion of the
balance sheet? And why is it in the Intangible Assets 18000
Accumulated Amortization -2700
same part with liabilities? How can
equity be a liability? You have to
stretch your mind a little. It makes Total Assets 174818
more sense to say that everything on
the liability/equity part of the balance
sheet is really funds, materials, and
services that have been invested in the Accounts Payable 8500
company or provided to the company. Notes Payable - Current 10000
That includes money invested by the Other Current Liabilities 12750
stockholders, money obtained from Total Current Liabilities 31250
banks to run the business, and money
that we owe to other businesses for
materials and services that they have Long Term Debt 75628
provided us. We refer to money that
we receive from banks and other Owner Equity 67940
institutions as debt financing. We refer
to money that we receive from Total Liabilities and owner Equity 174818
stockholders as equity financing.
But we don't owe anybody the
equity in a company, do we? If
everything is going well, we don't. If the company is going to go out of business, we do.
Under those circumstances, we would sell all the assets in the company, pay off all the
liabilities, and what was left would be distributed among the stockholders. Stockholders
put the money in the company and that money was used to purchase assets. Therefore,
the value of those assets would appear on the asset portion of the balance sheet. To make
the balance sheet balance, we have to show a corresponding value on the equity portion.
We can't make that entry under liabilities, because the money that stockholders invest is
not a liability. So there has to be a separate category for stockholders' investments in the
company, which is called stockholders' equity. If it were a non stock company, it would
be called owner's equity. See Figure 1 for the balance sheet of Consolidated Cromwell
Company, hereinafter called CONCROMCO or simply 3C. It is the example company
that will be used in this handbook.
So stockholders' equity is really the value of what is left when we subtract the
total liabilities from the total assets. But it is only an accounting approximation. That is
because it assumes that the assets could be liquidated for the value shown on the balance
sheet. In many cases that will not be so. It's the same when you sell your car, a car that
you financed through a bank. Let’s say the remainder of the loan is $400. You would try
to sell it for as much or more than the remaining bank loan. If you succeeded in selling it
for more, let's say $600, you would say that you had $200 equity in the car. In reality,
that may not happen. You may have to sell the car for less than the loan outstanding, let's
say $400. In this case you would have negative equity of $200, and you would have to
make up this amount out of your own pocket. The concept of negative equity daunts
some students, when in fact it is simple. Negative equity occurs in a business when
liabilities are greater than assets. In other words, when you subtract liabilities from assets
and you get a negative number, that number is an expression of the negative equity the
stockholders are experiencing or the extent to which the company has not been provided
with sufficient equity capital. It may also indicate that it has borrowed beyond its
capability to repay. It could eventually mean that the stockholders may have to come up
with more money; the company may have to try to make a payoff deal with its creditors
that would lessen its debt obligation; or the company may face bankruptcy.
While a one-year balance sheet can tell us much, consecutive balance sheets from
sequential quarters or years are invaluable. They show us annual trends in the case of
sequential years and intra-year trends in the case of quarters. It is, however, quite
difficult for the non-accountant to see data specific value from the raw numbers on a
balance sheet. We might, for example, see that our receivables increased 100% over the
past five years. On the surface, this could be viewed as bad. If our revenues increased by
300% during the same period, then it would be viewed as excellent. Why? Because now,
five years later, our receivables are a much smaller portion of our total current assets.
That is why we have to understand the limitations of analyzing raw financial data and
also understand that the calculation of financial ratios helps us make real financial and
management sense out of the data. In a very real sense, ratios turn raw data into usable,
THE INCOME STATEMENT:
The income statement is of more immediate value to the manager than the balance
sheet. It shows primary and secondary revenue totals as well as primary and secondary
expenses. Primary revenues are those that the company realizes as a result of its primary
business activities. For example, a company that produces clothing may generate money
from other ventures such as investments, the sale of property, and currency exchange.
These incomes have not been gained from its primary business function and must be
displayed as such.
Stockholders, investors, management, and bankers want to know how well the
primary business is performing. You also want to know so that you can gain an accurate
picture of the financial results of the company's operations. The income statement shows
the manager whether or not the company is on track to meet its objectives and
accomplish its mission.
It is not uncommon for
companies to publish quarterly
income statements; all of the CONSOLIDATED CROMWELL
publicly traded companies do. COMPANY, INC.
These are readily accessible on
the Internet. Financial advisors, INCOME STATEMENT (000)
investment firms, individual
investors, and institutions are 2002
constantly scrutinizing these
Net Sales $ 140,000
statements. You should do the Cost of Goods Sold $ 112,000
same when data are available. Gross Profit $ 28,000
Let's look at some of Administrative Expenses $ 9,000
the more common items found Selling Expenses $ 7,500
on the income statement. (See Research and Development $ 1,500
Figure 2.) Most income Reorganization Expenses
statements look the same and Currency Exchange $ 500
Write-off of in process R&D $
have a great deal in common.
That does not mean that they
all are. Some very complex Income from Operations $ 9,500
companies present their income
statements in more detailed Interest Expenses $ 6,000
form. The top line will Income before Taxes $ 3,500
generally be net revenues or net
sales. This is income that Income Taxes (Credit) $ 1,400
comes from the company's
Net Income $ 2,100
primary business and does not
include income from other Figure: 2
sources. It is net sales/revenue,
not gross income. It is net because it is the income that we have after all rebates, warranty
claims, and returns. It is the "top line." Next we will generally see “cost of sales", "cost of
services provided" in the case of a non manufacturing firm, “cost of goods sold" or some
variation on this theme. This item will include direct and indirect labor costs, the cost of
materials, waste, the cost of operating machinery, the cost of operating the physical plant,
and storage costs. Almost all manufacturing companies include the depreciation costs of
machinery and physical plant under cost of goods sold. The next item is generally called
the "gross margin", "gross income", or "gross profit." We get this amount by subtracting
the cost of goods sold from the net sales. It is the first crucial profit line on the income
statement. We will discuss more about this when we look at the profitability ratios.
The statement will next show the other expenses that we incur as a result of doing
business. They are referred to as operating expenses. These expenses can include, but are
not limited to, administrative expenses, marketing or sales expenses, officers' salaries,
and research and development. Income statements can vary a great deal. Some firms
make only one entry: general administrative and sales expenses. Just because a firm fails
to list research and development separately does not mean that it has no research and
development program. All it means is that it chooses not to publish that detailed figure
for common consumption.
Another major point should be made here. Many balance sheets and income
statements that are published for general consumption are usually heavily summarized
and are not intended to be used as a vehicle for in-depth analysis. So you have to do the
best that you can or "Go With What You Got" (GWWYG, pronounced Gweegee). Other
firms are more generous in the information that they provide. It all depends on the firm
and the detail that the firm feels that it must provide to stockholders, investors, and
financial institutions. The amount and detail of the information available will enhance or
diminish the value of any financial and management analysis made by the student when
using the income statement.
The next major item is called "operating income", "operating margin", or
"operating profit." They all mean the same thing. It is also referred to as earnings before
interest and taxes or EBIT. After operating income comes net interest expense or income.
Interest expense is subtracted from operating income to get the earnings before taxes or
EBT. Logically then, the next item is taxes. When you subtract taxes from income before
taxes, you get net income, net profit, or net margin. They all mean the same thing.
Income statements can be more complicated. They may also include such items as
interest income, extraordinary income or expenses, restructuring charges, and currency
exchange losses or gains. Generally accepted accounting practices usually dictate where
all entries will be put. Don't be confused by the complexity of the income statement.
They all contain the same essential ingredients and to one degree or another are amenable
to analysis. Remember that you are a manager, owner, or student who must be able to
make sense out of the statements.
THE STATEMENT OF CASH FLOWS:
The statement of cash flows provides you with additional information about the
financial and managerial activities and decision making of the company. It shows you
three major things: how the company gets its money, how the company spends its money,
and the beginning and ending cash. There is a connection between the statement of cash
flows and the balance sheet. The ending cash figure on the statement of cash flows is the
same dollar amount as the entry for cash on the balance sheet. So if you want to know
how the company wound up with a certain amount of cash at the end of the reporting
period, you have only to look at the statement of cash flows. An example of the statement
of cash flows is shown at Figure 3.
CONSOLIDATED CROMWELL COMPANY, INC
STATEMENT OF CASH FLOWS (000)
Cash flows from operating activities:
Net Income (loss) $ 2,100
Write-off of in-process R&D $ -
Depreciation and Amortization $ 3,479
Increase (decrease) in Working Capital $ (2,775)
Net Cash Provided (Used) by Operating Activities $ 2,804
Cash Flows from investing activities:
Purchases of fixed assets $ (19,932)
Acquisition of XYZ Corporation (net cash payments) $ -
Net Cash used in investing activities $ (19,932)
Cash Flows from financing activities:
Proceeds from issuance of long-term debt $ 20,628
Net cash provided by financing activities: $ 20,628
Net increase (decrease) in cash and cash equivalents $ 3,500
Cash and cash equivalents, Beginning of period $ 1,500
Cash and cash equivalents, End of period $ 5,000
Again, looking at a statement of cash flow for only one year may provide you
with limited information. You have to look at the statements for the past three to five
years. The statement of cash flows at Figure 3, above, shows some of the major and
minor headings that are used; both of these will vary somewhat depending on the type of
business that is reporting the information. You will, however, see a high degree of
uniformity between companies because of the uniform reporting standards that have
recently been adopted. On 3C's statement of cash flows, you will see three major areas of
cash movement in the company. These activities are:
a. Net cash from operating activities,
b. Net cash from investing activities, and
c. Net cash from financing activities.
The individual subheadings under each of the above show the more specific cash inflow
and outflow that has occurred. If you add each of these "nets" together, you will get the
net increase (decrease) in cash and cash equivalents. Then add this to the cash and cash
equivalents at the beginning of the period, and you have the cash and cash equivalents at
the end of the period.
The statement of cash flows is another piece to the puzzle that helps us to
understand the nature of the "cash streams" that are financing the operations and other
financial activities of the company. It complements the balance sheet and the income
Note to the Reader: Except where specifically indicated, all ratios and metrics will use
the financial data from the balance sheet, income statement, and statement of cash flows
in this chapter.
The Liquidity Ratios
There are two parts of the balance sheet that we use to calculate the two liquidity
ratios, the current ratio and the quick ratio. They are the company's current assets and its
current liabilities. See Figure 1, in Chapter 2, page 14 for 3C’s balance sheet:
THE CURRENT RATIO:
To calculate the current ratio, divide current assets by current liabilities; both
items are on the balance sheet:
Total Current Assets
= The Current Ratio, or
Total Current Liabilities
Cash + Cash Equivalents + Receivables + Inventory
= The Current Ratio
Accounts Payable + Notes Payable + Other Current Liabilites
Using the data from Figure 1, in Chapter 2:
= or simply
This tells us that for every $1.02 in current assets, 3C has one dollar in current liabilities.
From this we can infer that 3C may have sufficient current assets to meet its current
obligations. We would have to check the industry averages to see whether or not this is
the norm. But there is a clue here. If you had to liquidate all of your assets today to
satisfy your creditors, you would have to be able to liquidate your inventory for the full
value indicated on the balance sheet. Is that a likely prospect? Similarly, if you were
seeking additional credit, a potential loan agency may view a current ratio of 1.02/1 as an
unacceptable credit risk. The upside is that the creditor will probably look at the
seasonality of your business and your credit history. The downside is that you may not
get the loan.
THE QUICK RATIO (THE ACID TEST):
The Quick Ratio is also called the Acid Test. The thinking here is that we will
have a better idea of a company's liquidity if we eliminate the inventory from
consideration. It is the least liquid of the current assets, and it is questionable what value
it will actually have, if you must dispose of it quickly. To calculate the quick ratio,
subtract the inventory from total current assets and divide by the total current liabilities.
All these items are on the balance sheet. You will invariably get a smaller ratio than the
current ratio. For companies that have no inventory, the current ratio is the quick ratio.
Total Current Assets - Inventory
= The Quick Ratio, or
Total Current Liabilities
Cash + Cash Equivalents - Inventory
= The Quick Ratio
Accounts Payable + Notes Payable + Other Current Liabilites
The Quick Ratio:
Using balance sheet data from Figure 1 in Chapter 2:
31,950,000 − 15,000,000 16,950,000 .54
= = or simply
31,250,000 31,250,000 1
This tells us that for every 54 cents in current assets, 3C has one dollar in current
liabilities. Therefore, when we eliminate the inventory from consideration as a
liquid asset, it appears that 3C will have substantial difficulty in meeting its
The liquidity ratios, the current and the quick ratio, provide us with a great deal of
information, or at least indicators, about both the financial and management condition of
the company. Liquidity analysis, in the form of the quick and current ratios, gives us an
idea as to whether we have sufficient current assets to pay those bills. Should you
memorize the names of these ratios? The answer is yes. They are part of what a manager
should know and what a manager should commit to memory.
Accountants say that liquidity refers to the company's ability to meet its current
obligations. As managers we can think of it as our ability to pay our bills in the near
future. To pay those bills, we are going to need cash. Why? Cash is the most liquid asset
that we have and our creditors and suppliers want their bills paid in cash. We are not a
Liquidity is not a straight-forward issue. Any business has to be liquid enough to
pay its bills to continue operating. In this regard, there are factors of which we should be
aware. For example, does the company have an effective policy for identifying and
controlling uncollectible accounts? If you have a large accounts receivable that contains
mostly uncollectable accounts, it will distort the value of your analysis. You can’t easily
liquidate uncollectible accounts at their face value. You may not even be able to do that
with great difficulty.
One thing is certain, if you do not have the money to meet your current
obligations, you must pursue options to stay in business. One option is to go to the bank
for a short-term loan. Many businesses that have uneven cash flows from month to month
must do this. Their liquidity fluctuates wildly with the seasons. Some businesses are so
seasonal that they do as much as 70 percent of their annual sales in a three-month period
and 30 percent in the remaining nine months, such as Toys R Us and L.L. Bean. They
have no alternative but to rely on short-term loans to meet their operating expenses
during the slow-sales-part of the year.
When we talk about liquidity, we are really talking about either how much cash
we have on hand or the assets that we can reasonably convert to cash. Assets are things
that we own or that are owed to us by someone else. Some assets are easily turned to
cash; others are turned to cash only with some or considerable difficulty. A certificate of
deposit is easily turned into cash. Accounts receivable are quite different. Accounts
receivable are only as liquid as our ability to collect them. Let’s say that we have
numerous accounts receivable that past due for a long period of time, say 45 to 90 days.
These accounts may be uncollectable in the next 30-day period. In this case, our accounts
receivable are a questionable part of our liquidity, affecting our ability to pay our current
Inventory is also an issue. It is only as liquid as our ability to convert it to cash. It
is worth only what someone is willing to pay for it. In a worst case scenario, if we sold
off or auctioned off all of our inventory for cash to pay our current bills, we would have
nothing more to sell and would risk going out of business.
There is a contemporary saying in many businesses, particularly those in
manufacturing: "More inventory is bad." Manufacturers strive to create a zero
inventory situation. Cash tied up in inventory is cash that is not working for the
company. Similarly, retailers try to stock products that move quickly.
An option for the firm in financial difficulty is to try to restructure its obligations
and debt with its suppliers and creditors. It may, for example, pay all of its utility
bills each month but work out some sort of a deferred payment plan with its
suppliers and creditors. Suppliers usually get nervous when this happens because
they have already incurred the financial obligations associated with whatever they
provided the firm. Now they, the suppliers, are going to experience problems paying their
own current obligations. The supplier has the option of cutting the firm off or insisting on
cash payments for future supplies and arranging a negotiated payment each month on the
existing debt. Creditors also get nervous and are usually reluctant to extend further credit
to the firm, negating the possibility of any further debt financing. Investors who are
aware of this also become reluctant to put any money into the company, reducing the
probability of equity financing.
The Management Effectiveness Indicators of Liquidity
The liquidity ratios can give us an indication about strengths and weaknesses in
management, marketing, finance, production, and management information
systems. The following table is a list of possible strengths and weaknesses listed
by major management functional area for the results of liquidity ratios. These are
possibilities that are designed to help you focus on the management situation within the
organization. Remember the analysis caveat in item number 1, which was discussed on
page 6. We say that these are "possible" management strengths and weaknesses. You
must also check to make sure that the financial condition of the company was not caused
by external mitigating factors or unusual internal factors, such as recent acquisitions,
divestitures, restructuring, or cyclical expenditures.
If the possible strength and weakness indicators were indeed showing us
something about the company, we would use them as part of our basis to develop
strategies to build on the apparent strengths or develop strategies to minimize the effect
of or eliminate the possible weaknesses. In life as in business, information upon which
we do not act is a missed opportunity. Some of the possible management strengths listed
in the remainder of the handbook will also be listed as weaknesses. This is the case
because in one situation, the favorable external factors will permit us to carry out one
policy; however, when those same external factors become unfavorable, that policy is no
For example, if interest rates were low and sales were strong, a company could
carry more debt, because it could earn more in profit than it paid in interest on that
debt. If the external situation changed, however, and interest rates went up, the
company may not be able to pay the interest on its debt. Many financial policies
are determined by external factors over which the company has no control. Some of these
are opportunities for the company to exploit; others are threats, the effects of which it
must try to attenuate. For a more detailed list, see Appendix A.
POSSIBLE INTERNAL STRENGTH INDICATORS
LIQUIDITY STRENGTH MGT AREA
Hi cash Excess cash available to develop and implement new MGT
Hi inventory Sufficient inventory to meet customer demand. MKT
Low cash No excess funds just "sitting around" and not being MGT
Low cash All invested funds working for the company. MGT
Hi receivables Liberal credit policy to stimulate revenue growth. MKT
Low Aggressive receivables staff; decisive company policies MGT
receivables on credit.
POSSIBLE INTERNAL WEAKNESS INDICATORS
LIQUIDITY WEAKNESS MGT AREA
Hi overall Needlessly stockpiling cash and/or inventory. MGT
Hi overall "Strategic bunker mentality"; saving for a "rainy day." MGT
Hi cash No definite strategic plans. MGT
Hi cash Lack of a dividend plan. MGT
Hi cash Failure to upgrade current plant and equipment. MGT
Hi inventory Lack of inventory control system. IT
Hi inventory Loss of market share. MKT
Hi inventory Questionable purchasing practices. MKT
Hi inventory "If the customer may want it, we have to have it in MKT
stock" attitude; trying to be all things to all people
without a clearly defined target market.
Hi inventory Sales personnel not aggressive. MKT
Hi inventory Lack of adequate sales personnel. MKT
Hi inventory Lack of “new business development leadership." MGT
Hi inventory Ineffective sales manager. MKT
Hi inventory Keeping a non-competitive product or service too long. MKT
Hi inventory Ineffective strategic plan or lack of strategic plan. MGT
Hi inventory Management arrogance, e.g., “They buy what we sell!” MGT
Hi receivables Incompetent or ineffective receivables manager. MGT
Hi receivables Weak or untrained receivables staff. MGT
Hi receivables Lack of effective receivable policy. MGT
Hi receivables Indecisive management. MGT
The Activity Ratios
"Ahhhh, what's up doc?" (Attributed to Bugs Bunny)
There are four activity ratios with which you should be concerned. They are the
asset turnover ratio, the inventory turnover ratio, and the average collection period. Not
surprisingly, they give us an indication of how well we are managing our assets, how
well we are managing our inventory, and how well we are managing those to whom we
have sold a product, performed a service, or extended credit for that product or service.
Based on the repetitive use of the word "managing", we can conclude that the activity
ratios will tell us a great deal about the management of the firm. These ratios are easy to
THE TOTAL ASSET TURNOVER RATIO:
= Total Asset Turnover Ratio (Asset Turns)
Total Asset Turnover Ratio:
Let's calculate the asset turnover ratio for 3C using total assets. Get the net sales
and total assets from the income statement and balance sheet in Chapter 2.
= or simply
This gives us a total asset turn ratio of .8 to 1 (.8/1). The ratio tells us that for each dollar
in assets, there is eighty cents in sales. This ratio has to be tracked over time and
compared with similar other companies. Experience and comparison will tell us whether
this is an acceptable outcome.
THE NET FIXED ASSET TURNOVER RATIO:
= Fixed Asset Turnover Ratio
Net Fixed Assets
Net Fixed Asset Turnover Ratio:
To calculate the net fixed asset turnover ratio for 3C:
140,000,000 1.09 140 1.09
= or simply =
127,568,000 1 128 1
This gives us a fixed asset turn ratio of 1.09 to 1 (1.09/1). This tells us that for every
dollar in fixed assets, there is one dollar and nine cents in net sales.
The fixed asset turnover ratio is a variation of the asset turnover ratio. Here we
divide net sales by total fixed assets (our plant, machinery, and equipment). The
argument here would be that it would be a useful indicator to know just how our
well our fixed assets are performing. It’s a good argument. Many manufacturing
firms prefer to use this ratio instead of the "total asset turnover ratio."
The total asset turnover ratio and net fixed asset turnover ratio tell us how many
dollars or fractions thereof we are making for each dollar in total assets or fixed assets
that the firm owns. We spend money to buy assets so that those assets can make money
for the company. This ratio gives us an idea of how our assets are performing. Industry
averages and trend analysis are important in determining the significance of the ratio.
Use the ratio that makes the most sense or use both. I prefer net sales/total assets
because total assets represent all of the money that is invested in the company.
THE INVENTORY TURNOVER RATIO:
Cost of Goods Sold
= Inventory Turnover Ratio
Inventory Turnover Ratio:
Referring to Figure 1and 2 for 3C, in Chapter 2, we would divide the cost of
goods sold from the income statement by the inventory from the current assets
section of the balance sheet.
112,000 7.46 112 7.46
= or =
15,000 1 15 1
The inventory turnover ratio is an artificial way of telling us how many times we
have sold our inventory based on the dollar value of that inventory shown on the
balance sheet. Another way of saying this is: "How many times has the inventory
has turned over?" Inventory turns vary wildly from industry to industry. A
convenience store may turn its inventory 12 times a year, or once each month. A
franchised recreational vehicle dealership might turn its inventory only once a year.
To be more accurate, before we calculate this ratio, we actually should get the
dollar value of the inventory at four separate times during the year. Then average these
figures and use the average to calculate inventory turns.
Does the answer that we get when we calculate this ratio mean that we have sold
the entire inventory exactly the same number of times? No! Part of the inventory may be
turning over very rapidly, while part of the inventory may be turning over slowly. For
example, in a franchised auto dealership's service department, the spark plug inventory
may turnover 98 times a year, while the alternator inventory may turn over only four
times a year. What is financially sound? How many inventory turns does it take to keep
the company in business and making money for the owners or stockholders? It is not as
simple as this.
From a financial perspective, the number of inventory turns needed to insure
financial health varies greatly from industry to industry. The company's target market and
overall strategy has to be taken into consideration. The inventory turn ratio has
comparative analytical value. We can compare ourselves to other firms in the industry.
We can see trends over years in the number of times that we turn the inventory over. By
doing this, we convert raw data, inventory turns, into information. This information can
be used in management decision-making, the results of which become knowledge we can
apply again or modify as appropriate.
A slowing down in turns could indicate that too much money is tied up in
inventory that does not move quickly. Or it could be caused by external factors. A
recession or federal government fiscal policies could cause a lowering of demand. If the
company is involved in international trade, declining demand in overseas markets,
increased competition, or a strengthening of the U.S. dollar could also account for a
slowing down of net sales and hence a decline in the number of inventory turns. There is
a lesson to be learned here. Because of the interdependence of the economies of
countries, both large and small, economic changes in other countries can dramatically
affect the performance of domestic companies. A significant increase in the number of
inventory turns does not mean that a company is enjoying prosperity. Sometimes, firms
have no choice but to get rid of inventory at bargain prices, causing inventory turns to be
up but net profit to be stagnant or show a decline. So, there no virtue in winning the
“inventory turnover contest” if you wind up losing money.
Caution: This ratio is meaningless for companies that do not have saleable
products in inventory. Most service firms have a small inventory of office and
maintenance supplies. YOU SHOULD NOT calculate an inventory turn ratio for
these firms. It is irrelevant to calculate how many times your inventory of copy
paper, paper napkins, mops and brooms, and bathroom tissue turn over in a year.
That inventory may be turning over, but it does not represent sales.
THE AVERAGE COLLECTION PERIOD:
First, we have to calculate average daily sales. To do this, divide net sales by 360:
STEP ONE Annual Net Sales
= Average Daily Sales
Then we have to divide the receivables by the average daily sales.
STEP TWO = AverageCollection Period
Average Daily Sales
The Average Collection Period:
Calculate these ratios for 3C using the data from the balance sheet and income
statement in Chapter 2:
STEP ONE : Calculate Average Daily Sales = 388,889
STEP TWO : Calcualte Average Collection Period = 23 days
What we have actually calculated is the dollar amount of the average daily sales
for which we have not as yet been paid. Remember, this is just a daily average
that is calculated for analytical purposes; it does not necessarily represent 23
actual days of sales. If our average collection period is 23 days, it means that, on
average, we have 23 days of sales for which we have not been paid. The only way that
we can calculate the actual average collection period is to sum the age of all accounts
receivable and divide that total by the number of accounts receivable. The key is that we
have not yet been paid for products delivered or services rendered. We are in fact
extending an interest free loan to those accounts.
You should not be surprised to learn that at the operational level, companies know
the "age" of every account. In fact, the credit history of every client is well documented.
Most companies have a system for showing the "age" of their accounts receivable. They
will, for example, group together accounts that are equal to or less than 30 days old; have
a separate group for accounts that are 31 to 45 days old; have a group for accounts that
are 46 to 60 days old; and a final group for accounts receivable that are more than 60
The accounts receivable entry on the balance sheet tells us how much money we
are owed for the goods and/or services that we have already provided to someone. If the
average collection period for these accounts gets too long, the company may have
difficulty in paying its current obligations. Insufficient cash flow can force the company
to take out short-term loans to meet cash requirements. In an acute situation where the
company is too heavily in debt, the lending institutions could cut off this credit. In a
worst case scenario, the company could become insolvent and be forced into bankruptcy.
A company that is overly reliant on debt financing and does not have adequate equity
financing would be most vulnerable under these circumstances.
The Management Effectiveness Indicators of Activity
There are many factors within an organization that contribute to its success or
failure. There are also a number of factors, from a management perspective, that
should be taken into consideration when trying to understand the implications of
the activity ratios. With this in mind, tables have been constructed to illustrate
some of the major internal factors that contribute to asset turns, inventory turns, and
average collection period from a management perspective. Remember, assets just don't
"turn" by themselves. People, policies, practices, strategies, procedures, and leadership
cause assets to turn.
There are also external factors, over which the company has no control, that may
be the primary mitigating factors. These factors could determine asset turns, inventory
turns, or the average collection period regardless of the internal strengths and weaknesses
of the organization. They include: economic recession, economic growth, change in
consumer demand for better or worse, the opening up of new, lucrative markets,
increased competition from higher quality and lower priced products, or a sudden decline
in viable competition. A longer list of external factors that can affect business operations
is shown at Appendix A.
Possible Internal Strength Indicators
RATIO CONDITION MGT
Hi Well-defined target market.* MKT
Hi Growing demand for product.* MKT
Hi Aggressive sales force.* MKT
Hi Well- defined goals, strategies, and objectives.* MGT
Hi Management encourages creativity and change. MGT
Hi Effective total quality management program.* MGT
Hi Shared values and expectations.* MGT
Hi Assets appropriate for the mission. MGT
Hi Effective human resource management policies. MGT
Hi Motivated, committed work force. MGT
Hi High levels of productivity. MGT
Hi Efficient, up-to-date physical plant. PRD
Hi Effective maintenance and replacement policy. PRD
Hi Effective and efficient waste control program. PRD
Hi Effective and efficient quality control programs. PRD
Hi Effective system for collecting, analyzing, and distributing IT
information throughout the organization.
* The asterisked management and marketing factors listed
above also apply to inventory turns.
Hi Responsiveness to market demand. MKT
Hi Responsiveness to customer needs. MKT
Hi Efficient distribution system. MKT
Hi Effective working relationship with suppliers. MKT
Hi Efficient, computerized, inventory control system. IT
Hi Prompt return to suppliers of unused or slow moving PRD
Hi Effective and efficient inventory control policies. PRD
Hi Efficient purchasing policies. PRD
Average Some of the factors will be identical to the receivable factors
Collection under the liquidity ratios. They are worth repeating because of
Period the importance of this activity to management. The average
collection period is the specific ratio that deals with the
Lo Decisive collection policies. FIN
Lo Aggressive accounts receivable staff. FIN
Lo Excellent accounts receivable record keeping. FIN
Lo Competent receivables manager. FIN
Lo Effective relationships with clients. MGT
Lo A high-quality list of clients. MGT
Lo Appropriate incentives for early or on-time payment. MGT*
Lo Appropriate credit terms for appropriate clients, in other MGT*
words, firm doesn't have a credit policy that encourages late
payment or that gives credit to non-deserving clients.
Possible Internal Weakness Indicators
RATIO CONDITION MGT
The possible internal weaknesses that we could associate with
low asset turns, low inventory turns, and a high average
collection period are the reverse of those items that were listed
under strengths. Therefore, they will not be repeated for the
sake of showing this reversal. Students and managers can
easily do these themselves. There are several weaknesses,
however, that are not readily apparent by reversing the
strengths, particularly for the average collection period.
Lo Excessively stringent credit policy. MGT
Lo Over reliance on cash and cash equivalent payments. MGT
Lo A "cash on delivery" policy for all clients. MGT
The Leverage or Debt Ratios
There are three leverage ratios with which we should concern ourselves: the debt
to asset ratio, the debt to equity ratio, and the times interest earned ratio. They are
important because they give us an idea about how the company is being financed,
the degree to which it relies on debt financing, and its ability to generate
sufficient revenue to discharge its debt obligations. These ratios help us determine
whether or not the company can attract debt financing and its vulnerability to an
The financial implications of the leverage ratios can be far-reaching and can affect
the continued viability of the company. First, few companies can afford to do business
without borrowing money. Major sources of loans are banking institutions. Banks are
primarily interested in their own profits; therefore, banks need to determine the financial
health of their client companies. They want to know if the companies can "carry the
debt", that is, make the payments on the loan in a timely manner. Simply put, when the
bank loans money, it wants it back with interest and on time. Banks are profit-making
organizations; they are accountable to their stockholders just like any other company.
Before we go into how the ratios are calculated, we should discuss the term
"leverage." Why use the term leverage? The answer to that question is tied to the
discipline of physics. In physics we learn that we can use a bar (lever) and a fulcrum to
create a mechanical advantage that helps us to move heavy objects more easily.
Similarly, in business we can use the assets of a company, its growth potential, and/or its
management prowess as a lever and a fulcrum to attract debt financing for the company.
When we have reached a point that banks are no longer willing to loan us any more
money, we tend to say that the company is "leveraged out" as far as it can go. That means
that banks feel that the company is incapable of satisfying the obligations of any more
debt. It may also mean that the bank feels that the assets of the company will not be able
to generate enough money if they are sold to cover any additional debt. The bank may
say that we do not have sufficient collateral to cover the debt.
When we say that a company is in a strong leverage position, we mean that it can
afford to take on more debt financing. The reverse is true for a company in a weak
leverage position. Leverage then is directly tied to a company's ability to either attract
financing or take on the obligation of additional debt. Debt is debt. It doesn't make any
difference whether it is short term or long term, or whether it is from a bank or obtained
through the issuance of bonds. A debt is any obligation that a company incurs that must
be paid back, almost always with interest. If the owner of a business or the uncle or aunt
of the owner gives the business a loan, that is also debt.
THE DEBT TO ASSET RATIO AND LONG TERM DEBT TO ASSET RATIO:
The total debt to asset ratio, also called The Debt Ratio:
Total Debt (Liabilities)
= Total Debt to Asset Ratio, The Debt Ratio
The Debt to Asset Ratio:
Again we get 3C’s debt and asset information from the company's balance sheet
in Chapter 2.
106,878,000 .61 107 .61
= or simply =
174,818,000 1 175 1
The ratio tells us that for every dollar in assets, we have 61 cents in debt. This ratio is
meaningful as a comparison of the relationship of our debt to our assets. It could have
ultimate value to a lending institution that wants its loans secured by assets. If that were
the case, in this situation we could only use 39% of our assets to secure additional debt.
The debt to asset ratio shows management and the banks the relationship
between the assets of the company and the amount of debt owed by the company.
It does not show the amount of assets that were actually purchased by debt
financing. In reality, equity financing could have purchased all of the assets.
Assets are either purchased with cash, debt or equity financing. The ratio actually shows
us how much of the debt of the company is covered by assets.
So, if we have a situation where there are 200,000 dollars in assets and 100,000
dollars in debt, we will have a debt ratio of .5 to 1. We divided the total assets by total
debt. The .5 tells us that for each 50 cents in debt, there is one dollar in assets. Is this
good or bad? It all depends on the industry. It could also depend on the current activities
of the company. For example, a company like 3C, our case company for this handbook,
recently used debt financing for a substantial acquisition. In this case, we should expect
that for a period of time its debt ratio would be higher than the industry average. We
would also expect that over time, the company would be engaged in strategies to improve
its leverage position as it "digested" the acquisition and made it an integral part of the
The long term debt (long term liabilities) to asset ratio:
Total Long Term Debt
= Total Long Term Debt to Asset Ratio
The Long term Debt to Asset Ratio:
Now we'll calculate 3C’s long-term debt to asset ratio:
75,628,000 .43 76 .43
= or simply =
174,818,000 1 175 1
This ratio tells us that for every dollar in assets we have about 43 cents in long-term debt.
About 43% of our assets are covered by long term debt.
The long term debt to asset ratio is an alternative or complement to the total debt
to asset ratio. Be careful when you use it. It can provide a misleading picture of the
company's liability structure, particularly when a company is heavily reliant on short-
term debt and not on long term debt. Eliminating the short-term debt from your analysis
in this case can lead to a false or inaccurate interpretation. When in doubt, use both ratios.
That will give you a more complete understanding of the leverage position of the
It is also obvious from our analysis that while the company is heavily reliant on
long-term debt (.43/1), it also has substantial short-term debt. We know this because the
two ratios are dissimilar, .61/1 for the total debt to asset ratio versus .43/1 for the long-
term debt to asset ratio. By subtracting .43 from .61, we can see that the company also
has 18 cents in short term debt for every dollar in assets (or .18/1). We can verify this
figure by dividing the total current liabilities by total assets, 31,250,000 by 174,818,000
(or simply 31,250 by 174,818). This also gives us a ratio of .1787 to 1, or rounding off,
THE DEBT TO EQUITY RATIO:
= The Debt to Equity Ratio
Total Stockholders' or Owners' Equity
Debt to Equity Ratio: Let's calculate the debt to equity ratio for 3C. Again, we
refer to the balance sheet in Chapter 2.
106,878,000 1.57 107 1.57
= or simply =
67,940,000 1 68 1
This means that for every dollar and fifty-seven cents of borrowed money (debt) there is
one dollar in money invested by 3C’s stockholders (equity). Conclusion: the bank has
more money invested and at risk in the company than the stockholders. Borrowing
additional money will be very difficult for this company.
The debt to equity ratio shows us the comparison of the amount of money that the
company has borrowed from creditors to the amount of money that the
stockholders/owners have put in the company. The ratio is important because it
gives lenders an idea of the financial vulnerability of the company, as well as
inability to attract additional equity financing. Lending institutions get increasingly
concerned when debt financing exceeds equity financing. Why? Because it means that
the lending institution has more invested in the company than the stockholders/owners of
the business. Banks are not philanthropic institutions; they want reasonable safeguards
that the money that they are lending will be repaid. As an aside, remember that
stockholders of the bank also want to enjoy a profit on their investment. Banks are
accountable to their stockholders for the financial health of the bank.
The debt ratio is not an issue if the company does not intend to borrow. However,
reality for most companies is that at some point, they must borrow money to operate. As
part of the lending process, and as a result, banks will look at the amount of money that
the stockholders/owners have invested in the company. They will also look at the amount
that the company has borrowed from banks or acquired with other loan instruments.
For example, if the company has $2,500,000 in debt and $1,000,000 in equity, the
debt to equity ratio would be 2.5 to 1. That means that for every $2.50 cents in
debt, there is one dollar in equity in the company. Who cares? The banks do; any
serious investor in the company should care. What this means is that the banks
have two and one half times more money invested in the company than the stockholders.
A company that is heavily in debt, with a debt to equity ratio of 2.5to 1, is very
vulnerable to changes in the domestic and, if applicable, the international economic
environments, specifically to adverse changes in the prime interest rate. That could prove
to be a very vulnerable position for the bank.
Banks will generally loan out money at an interest rate that is either at or above
the prime rate. The interest they charge will depend on the creditworthiness of the
borrower. The prime rate is the rate that banks charge their most creditworthy customers.
Usually, the interest rate on the loan varies as the prime rate varies; it is not "locked in"
for the life of the loan. If your company can comfortably borrow $10,000,000 at 1
percentage point over a prime rate of 6.5%, it may not be able to afford the cost of
carrying the debt if the prime rate goes to 15%. Why? Because the interest charges on
that loan have more than doubled. Your "rapid-fire" response to this may be something
like: "We'll pass the additional debt service cost on to the consumer." That’s great if you
can do it; most businesses cannot afford to do that because there is simply too much
regional, national, and international competition. In 1979-80, when the prime rate
hovered near 20%, new car sales plummeted in the United States as consumers bought
more affordable, less expensive, used cars. Home sales also dropped dramatically for the
same reason. Many new car dealers were forced out of business because they could not
pay the principal and the vastly greater amount of interest on their loans.
What's the bottom financial line for a company? The higher the debt to equity
ratio, the less likely that the company will be able to attract debt financing, the more
vulnerable it is during an economic downturn. The latter condition presumes that the
company has competitors and/or is under pressure to deliver a high quality product or
service at a reasonable price within its market niche.
THE TIMES INTEREST EARNED RATIO (THE NUMBER OF TIMES THAT
THE INTEREST IS COVERED):
Operating Income (EBIT) Times Interest Earned or
Interest Expense Times the Interest is Covered
Times Interest Earned Ratio: Calculate this ratio for 3C with the operating
income and interest expense from the income statement in Chapter 3.
9,500,000 1.58 95 1.58
= or simply =
6,000,000 1 60 1
This means that for every dollar and fifty-eight cents in operating income, 3C has one
dollar in interest expense, or its operating income is 1.75 times its interest expense. It has
earned its interest 1.75 times. Is this sufficient to satisfy 3C's creditors? We would have
to know what the creditors' expect in this area. We would also have to check the pertinent
The ramifications of the times interest earned ratio are closely tied to the debt to
equity ratio and the total debt to asset ratio. The financial implications of this ratio
are pretty straightforward. It tells lenders about the relative ability of the company
to pay the interest on its debt obligations. Looking at it realistically, when you
divide the operating income by the interest on the debt, if you come up with a figure that
is less than one, it means that there is not enough operating income being generated to
pay the interest on the debt. This sends up a red flag for the lender and suggests that the
company may not be financially strong enough to carry more debt. It is also a signal to
the company that it may have to develop strategies to change its debt and/or equity
structure or to reduce its cost of sales or operating expenses.
THE MANAGEMENT EFFECTIVENESS INDICATORS OF
Not only does debt affect the financial situation of the company, it has clear
implications for management and management decision-making. Most strategies
cost money to implement; some much more than others. An organization must
either have the money to implement or it must be able to attract financing. If it does
not have the financial wherewithal and cannot attract it, the consequences for the
company are serious. The debt to asset ratio and the debt to equity ratio are strongly
correlated with each other. If you have a high debt to asset ratio, you will almost always
have a high debt to equity ratio. The same is not true for the times interest earned ratio.
You could have a low debt to asset and a low debt to equity and still have a low or
unfavorable times interest earned ratio. That is because the times interest earned ratio is
dependent on a healthy income statement, while the other two ratios are dependent on a
healthy balance sheet.
Possible Internal Strength Indicators
RATIO CONDITION MGT
Lo Company able to assume more debt. FIN
Lo May be able to get most favorable interest rate. FIN
Lo Can contemplate goals and strategies that are unavailable MGT
without additional financing.
Lo Can contemplate expanding into new geographic areas-usually MKT
a high cost strategy.
Lo Can consider purchasing or buying into companies that are MGT
their primary suppliers-a high cost strategy.
Lo Makes the company more attractive as a strategic partner. MGT
Lo Company is more attractive to lenders because FIN
stockholders/owners have a large stake in the company.
Lo Can contemplate a wider range of strategic options because MGT
debt financing is a viable option.
Hi Company is using borrowed money. In a strong economy with FIN
low interest rates, this means that the return on equity for
stockholders will be higher.
Lo Makes the company more attractive as a strategic partner. MGT
Hi Company is attractive to lenders. FIN
Hi Company is attractive to potential investors. FIN
Possible Internal Weakness Indicators
RATIO CONDITION MGT
Debt to asset
Hi Company will be unable to upgrade or replace expensive PRD
means of production.
Hi Companies unappealing to both lenders and investors. FIN
Hi Moderate and high cost strategies cannot be contemplated, MGT
restricting the strategic options of the company.
Hi May not be able to aggressively pursue strategic opportunities MGT
as they develop because of lack of financing.
Lo Possible takeover target, because the company is in an MGT
excellent leverage position.
Hi Lenders and investors view the company as high risk. FIN
Hi Either there is too much debt or too little equity in the FIN
company, forcing the company to pursue equity financing. If
company is in an unfavorable leverage position; it will not get
sufficient equity financing.
Hi In a weak economy with rising interest rates, company will FIN
probably lose money.
Lo Possible takeover target because the company may not be MGT
Lo Unattractive to investors and lenders. FIN
Lo Restricts the strategic options of the company. MGT
The Profitability Ratios
There are six profitability ratios with which we must be concerned. They are the
gross profit, operating profit, net profit, return on equity, return on assets, and the
earnings per share. You could make a powerful argument that profitability is really the
only thing that counts. While that may be true, you will not be profitable unless you can
pay your bills (liquidity), are generating an adequate amount of business (activity), and
have a viable debt position (leverage).
THE PROFIT MARGINS:
GROSS PROFIT MARGIN:
= answer × 100 = Gross Margin as a Percent of Net Sales
The Gross Profit Margin:
To calculate the gross margin for 3C:
= .20 × 100 = 20% or simply = .20 × 100 = 20%
The result of this operation is very significant. It tells us that 80% of the money from our
net sales has been used to manufacture 3C's products. Only 20% is left for all of the other
expenses that the company incurs.
OPERATING PROFIT MARGIN:
= Answer × 100 = Operating Profit as a Percent of Net Sales
The Operating Profit Margin:
To calculate 3C’s operating margin:
= .0678 × 100 = 6.78% or simply = .0678 × 100 = 6.78%
This tells us that 13.22% of the money from our net sales (gross margin, 20%, minus
operating margin, 6.78%) is being used for operating expenses. This figure seems high
and should be a concern to us.
Think about this: If we could reduce our operating expenses to ten percent of net
sales, it would improve our operating profit by 3.22% to 8.8%. That is a 3.22% increase
in operating profit. Net profit, after taxes, would increase by .0202% (.0322 times .40, the
tax rate, = .012; .0322 minus .012 = 0202), resulting in a new net profit for 3C of 3.52%
(1.5% + 2.02%) without manufacturing or selling any additional product. That would put
a small smile, or perhaps a large smile, on the stockholders' faces.
NET PROFIT MARGIN:
= Answer × 100 = Net Profit Margin as a Percent of Net Sales
The Net Profit Margin: To calculate the net profit margin for 3C:
= .015 × 100 = 1.5% or simply = .015 × 100 = 1.5%
This seems rather low, but we can't be sure. This result, however, should act as a "red
flag" that signals us to look for answers or ask questions. Is this normal for companies in
this industry? Have any unusual external factors conspired to cause this to happen? Have
any unusual activities internal to the company contributed to the seemingly low margin?
What about the leadership of the company? Are we going in the right direction? Or is this
an anomaly caused by the recent acquisition?
The profit margins: From a financial point of view, the profit margins give us an
opportunity to view the income and costs of a company that are associated with
its primary business operations and with extraordinary financial occurrences in an