Chapter 23
Ratio analysis
How do you know if a firm is doing well, is an industry leader, or if it can meet its debt obligations? Ratio analysis is a form of financial statement analysis that is used to obtain a quick indication of a firm’s financial performance in several key areas.
When to use it
- To compare a firm’s financial performance with industry averages.
- To see how a firm’s performance in certain areas is changing over time.
- To assess a firm’s financial viability – whether it can cover its debts.
Origins
The first cases of financial statement analysis can be traced back to the industrialisation of the USA in the second half of the nineteenth century. In this era, banks became increasingly aware of the risks of lending money to businesses that might not repay their loans, so they started to develop techniques for analysing the financial statements of potential creditors.
These techniques allowed banks to develop simple rules of thumb about whether or not to lend money. For example, during the 1890s the notion of comparing the current assets of an enterprise to its current liabilities (known as the ‘current ratio’) was developed. Gradually, these methods became more sophisticated, and now there are dozens of different ratios that analysts keep track of.
What it is
There are four main categories of financial ratios. Consider the following financial results for three global firms in the smartphone industry:
| Firm A | Firm B | Firm C | |
|---|---|---|---|
| Net sales | 217,462 | 170,910 | 17,497 |
| Cost of sales | 130,934 | 106,606 | 10,138 |
| Gross margin | 86,528 | 64,304 | 7,359 |
| Net income (loss) | 28,978 | 37,037 | (1,017) |
| Total shareholders’ equity | 142,649 | 123,549 | 9,169 |
| Accounts receivable, net | 23,761 | 13,102 | 3,994 |
| Accounts payable | 1,002 | 22,367 | 2,536 |
| Inventories | 18,195 | 1,764 | 1,107 |
| Land and buildings | 71,789 | 3,309 | 779 |
| Cash equivalents | 57,751 | 146,761 | 5,061 |
| Total assets | 203,562 | 207,000 | 34,681 |
Looking at the raw figures, we can see that Firm A has the highest sales, Firm B has the highest net income (among other marketing leading figures) and Firm C has the lowest level of inventory relative to its sales. In order to compare one firm’s results against another’s, the creation of common, standardised ratios is needed. The four major categories of ratios are as follows:
- Profit sustainability: How well is your firm performing over a specific period? Will it have the financial resources to continue serving its customers tomorrow as well as today? Useful ratios here are: sales growth (sales for current period/sales for previous period), return on assets (net profit/total assets) and return on equity (net profit/shareholders’ equity).
- Operational efficiency: How efficiently are you utilising your assets and managing your liabilities? These ratios are used to compare performance over multiple periods. Examples include: inventory turns (sales/cost of inventory), days receivable (accounts receivable/[sales/365]) and days payable (accounts payable/[cost of goods sold/365]).
- Liquidity: Does your firm have enough cash on an ongoing basis to meet its operational obligations? This is an important indication of financial health. Key ratios here are: current ratio (current assets/current liabilities) and quick ratio (cash + marketable securities + accounts receivable/current liabilities).
- Leverage (also known as gearing): To what degree does your firm utilise borrowed money and what is its level of risk? Lenders often use this information to determine a firm’s ability to repay debt. Examples are: debt-to-equity ratio (debt/equity) and interest coverage (EBIT/interest expense).
These are some of the standard ratios used in business practice and are provided as guidelines. Not all these ratios will provide the information you need to support your particular decisions and strategies; you can also develop your own ratios and indicators based on what you consider important and meaningful to your firm.
How to use it
By comparing the ratio of a figure – or a combination of figures – to another figure, trends can be observed. Using just the data from the table below, the following ratios can be created:
| Firm A | Firm B | Firm C | |
|---|---|---|---|
| Inventory turns | 7.2 | 60.4 | 9.2 |
| Days inventory | 50.7 | 6.0 | 39.9 |
| Days receivable | 39.9 | 28.0 | 83.3 |
| Days payable | 2.8 | 76.6 | 91.3 |
| ROA | 14.2% | 17.9% | –2.9% |
| ROA, excluding cash and cash equivalents | 19.9% | 61.5% | –3.4% |
| ROE | 20.3% | 30.0% | –11.1% |
You can see that while Firm A is generating the most revenue, Firm B is likely to be an industry leader because it is very liquid, efficient and profitable. Having this standardised set of ratios allows managers to make better decisions – for example, which firms to invest in and which firms to monitor. Shareholders also use ratios to understand how their firms are performing versus their peers.
Top practical tip
Make sure to calculate a number of different ratios to ensure you get an accurate picture. Each ratio gives some insight, but the more you have, the more rounded your view becomes. And as with all forms of financial analysis, ratios don’t provide the ‘answer’ as to why a firm is performing well or badly — they are simply a way of homing in on the key questions that need to be answered in a more considered way.
Top pitfall
For ratios to be meaningful they need to be based on accurate financial information, otherwise you run the risk of falling into the ‘garbage in—garbage out’ trap. One key mistake is comparing fiscal year results for a number of comparable firms but failing to recognise that firms have different fiscal year-ends (some are at the end of January, others have a year-end in June). Ratios also are only really meaningful when used in a comparative way — for example, looking at how a set of ratios changes over time in the same firm, or how a number of competing firms have very different ratios.