Ratio analysisRatio analysis is used to evaluate relationships among financial statement items. The ratiosare used to identify trends over time for one company or to compare two or more companiesat one point in time. Financial statement ratio analysis focuses on three key aspects of abusiness: i. Liquidity ii. Profitability iii. Solvency.
Liquidity ratios:Liquidity ratios measure the ability of a company to repay its short-term debts and meet unexpected cash needs.Current ratio: The current ratio is also called the working capital ratio, as working capital is the differencebetween current assets and current liabilities. This ratio measures the ability of a company to pay its currentobligations using current assets. The current ratio is calculated by dividing current assets by current liabilities. 2011 2010 Current assets $38,366 $38,294 Current liabilities 27,945 30,347 Current ratio 1.4 : 1 1.3 : 1 This ratio indicates the company has more current assets than current liabilities. Different industries have different levels of expected liquidity. Whether the ratio is considered adequate coverage depends on the type of business, the components of its current assets, and the ability of the company to generate cash from its receivables and by selling inventory.
Acid-test ratio. The acid-test ratio is also called the quick ratio. Quick assets aredefined as cash, marketable (or short-term) securities, and accounts receivable and notesreceivable, net of the allowances for doubtful accounts. These assets are considered tobe very liquid (easy to obtain cash from the assets) and therefore, available forimmediate use to pay obligations. The acid-test ratio is calculated by dividing quickassets by current liabilities. 2011 2010 Cash $6,950 $6,330 Accounts receivable, net 18,567 19,230 Quick Assets $25,517 $25,560 Current Liabilities $27,945 $30,347 Acid-test ratio .9 : 1 .8 : 1The traditional rule of thumb for this ratio has been 1:1. Anything below this level requiresfurther analysis of receivables to understand how often the company turns them into cash. Itmay also indicate the company needs to establish a line of credit with a financial institution toensure the company has access to cash when it needs to pay its obligations.
Receivables turnover:. The receivable turnover ratio calculates the number of times in an operatingcycle (normally one year) the company collects its receivable balance. It is calculated by dividing net creditsales by the average net receivables. Net credit sales is net sales less cash sales. If cash sales areunknown, use net sales. Average net receivables is usually the balance of net receivables at the beginning ofthe year plus the balance of net receivables at the end of the year divided by two. If the company iscyclical, an average calculated on a reasonable basis for the companys operations should be used such asmonthly or quarterly. Calculation of Receivables Turnover 2011 2010 2009 Net credit sales $129,000 $97,000 Accounts receivable 18,567 19,230 $17,599 Average receivables (18,567+19,230)/2= (19,230+17,599)/2= 18,898.5 18,414.5 Receivables turnover $129,00/$18,898.5 = $97,00/$18,414.5 = 6.8 times 5.3 times
Inventory turnover: The inventory turnover ratio measures the number of times the company sellsits inventory during the period. It is calculated by dividing the cost of goods sold by average inventory.Average inventory is calculated by adding beginning inventory and ending inventory and dividing by 2.If the company is cyclical, an average calculated on a reasonable basis for the companys operationsshould be used such as monthly or quarterly. 2011 2010 2009 Cost of goods sold $70,950 $59,740 Inventory 12,309 12,202 $12,102 Average inventory (12,309+12,202)/2= (12,202+12,102)/2= 12,255.5 12,152 Inventory turnover $70,950/$12,255.5= $59,740/$12,152= 5.8 times 4.9 times
Profitability ratios: Profitability ratios measure a companys operating efficiency, including its ability to generate income andtherefore, cash flow. Cash flow affects the companys ability to obtain debt and equity financing.Profit margin: The profit margin ratio, also known as the operating performance ratio, measures thecompanys ability to turn its sales into net income. To evaluate the profit margin, it must be compared tocompetitors and industry statistics. It is calculated by dividing net income by net sales. 2011 2010 Net income/(loss) $ 8,130 Net sales 129,000 Profit margin 6.3% (1.4%)
Asset turnover: The asset turnover ratio measures how efficiently a company is using itsassets. The turnover value varies by industry. It is calculated by dividing net sales by averagetotal assets. 2011 2010 2009 Net sales $129,000 $97,000 Total assets 114,538 118,732 $102,750 (114,538+118,732)/2= (118,732+102,750)/2= Average total assets 116,635 110,741 Asset turnover $129,00/$116,635= $97,00/$110,741 = 1.1 times .9 times
Return on assets: The return on assets ratio (ROA) is considered an overall measure of profitability. Itmeasures how much net income was generated for each $1 of assets the company has. ROA is a combination ofthe profit margin ratio and the asset turnover ratio. It can be calculated separately by dividing net income byaverage total assets or by multiplying the profit margin ratio times the asset turnover ratio. The information shown in equation format can also be shown as follows: 2011 2010 2011 2010 Net income/(loss) $ 8,130 $(1,400) Profit margin 6.3% (1.4%) Average total assets 116,635 110,741 Asset 1.1 times .9 times turnover Return on assets 6.97% (1.3%) Return on 6.93% * (1.3%) assets
Return on common stockholders equity. The return on common stockholders equity(ROE) measures how much net income was earned relative to each dollar of common stockholdersequity. It is calculated by dividing net income by average common stockholders equity. In a simplecapital structure (only common stock outstanding), average common stockholders equity is theaverage of the beginning and ending stockholders equity. Calculation of Return on Common Stockholders Equity 2011 2010 2009 Net income/(loss) $ 8,130 $ (1,400) Total stockholders equity 71,593 65,385 $68,080 Average stockholders (71,593+65,385)/ = (65,385+68,080)/ = 2 2 equity 68,489 66,732.5 Return on common $8,130/ $(1,400)/ $68,489= $66,732.5= stockholders equity 11.9% (2.1%)
Solvency ratiosSolvency ratios are used to measure long-term risk and are of interest to long-term creditors and stockholders.Debt to total assets ratio. The debt to total assets ratio calculates the percent ofassets provided by creditors. It is calculated by dividing total debt by total assets.Total debt is the same as total liabilities. 2011 2010 Current liabilities $27,945 $ 30,347 Long-term debt 15,000 23,000 Total debt $ 42,945 $ 53,347 Total assets $114,538 $118,732 Debt to total assets 37.5% 44.9% The 2011 ratio of 37.5% means that creditors have provided 37.5% of the companys financing for its assets and the stockholders have provided 62.5%.
Times interest earned ratio: The times interest earned ratio is an indicator of thecompanys ability to pay interest as it comes due. It is calculated by dividing earnings beforeinterest and taxes (EBIT) by interest expense. 2011 2010 Income before interest expense and income taxes Income (loss) before taxes $13,550 $(2,295) Interest expense 1,900 1,500 EBIT $15,450 $ (795) Interest Expense $ 1,900 $ 1,500 Times interest earned 8.1 times N/M A times interest earned ratio of 2–3 or more indicates that interest expense should reasonably be covered. If the times interest earned ratio is less than two it will be difficult to find a bank to loan money to the business.