You have prepared the latest financial statements for a client. You need to let the client's management and your boss know how the company is doing. The company had a profit for the year. Does that mean you should give a positive report? Does it necessarily mean good results in the future?
Additional analysis of the numbers in the financial statements is necessary to answer these questions. Let's look at some steps that start with financial statement numbers and lead you to a supportable conclusion about the company's health. These steps include:
- Calculate the ratios.
- Compare ratios with industry averages.
- Compare ratios with competitors' ratios.
- Compare ratios over time.
- Dive deeper into your analysis.
Calculate the ratios
Accountants use ratios to chart a company's progress, uncover trends, and point to potential problem areas in a business. Financial ratios compare different numbers from the balance sheet, income statement, and cash flow statement.
These ratios are grouped into categories:
Liquidity ratios A picture of a company's short-term financial situation or solvency.
Asset ratios How efficient a company is in its operations and use of assets.
Profitability ratios The return on sales and investment.
Market ratios How book values relate to the company's market value.
Debt ratios How much debt is used compared to the owner's investment.
There are many ratios that can be calculated in each of these categories. The following discussion includes a couple of examples from each.
There is no absolute for a good value in any one of the ratios. However, some ratios have published ranges that are acceptable, and this information is included.
Liquidity ratios are probably the most commonly used of all the financial ratios. They show the ability of a business to quickly generate the cash needed to pay its bills.
- Current ratio The current ratio is calculated by dividing current assets by current liabilities. This ratio is the standard measure of any business's financial health. It tells you whether the business is able to meet its current obligations by measuring if it has enough assets that it expects to convert to cash in the next year to cover the liabilities it needs to pay in the next year. The standard current ratio for a healthy business is 2, meaning it has twice as many assets as liabilities. There is variation in this standard, depending on the company's industry and which assets are included in its current assets. At a minimum, the current ratio should be greater than 1.
- Quick ratio To calculate the quick ratio:
- Calculate current assets without including inventory.
- Divide the value from step 1 by current liabilities.
The quick ratio is commonly referred to as the "acid test." It indicates if a firm has enough short-term assets (without selling inventory) to cover its immediate liabilities. This ratio recognizes that, for many firms, inventories could not be turned into cash easily to meet an obligation. The optimal quick ratio is 1 or higher.
Asset ratios tell you whether the company is making the best use of its assets.
- Inventory turnover To calculate the inventory turnover ratio:
- Calculate your average inventory value over the year.
- Divide total sales by the value from step 1.
This ratio indicates how fast the company is turning over its inventory. The use of average inventory helps to account for any seasonal effects on the ratio. A "good" inventory turnover rate is, of course, highly dependent on the type of inventory the company holds. Because inventories are the least liquid form of asset, a high ratio is generally positive.
- Fixed assets turnover The fixed assets turnover ratio is calculated by dividing total sales by fixed assets. This ratio measures how productively the firm is managing its fixed assets to generate sales. Generally speaking, a higher ratio is better because a high ratio indicates that the business has less money tied up in fixed assets for each dollar of sales revenue. A declining ratio may indicate that they have overinvested in plant, equipment, or other fixed assets.
Profitability ratios are probably the most important indicators of the business's financial success. These ratios reflect the combined effects of the firm's asset and debt management. They demonstrate the performance and growth potential of the business.
- Return on assets To calculate the return on assets ratio:
- Calculate your average total assets value over the year.
- Divide net income by the value from step 1.
This ratio indicates the average return that the company is generating on its assets. You can compare this rate to the interest rate that the company pays to borrow funds. If the return on assets is above the borrowing rate, the company is profitable.
- Return on equity To calculate the return on equity ratio:
- Calculate your average owner's equity value over the year.
- Divide net income by the value from step 1.
This ratio indicates what return the company is generating on the dollars invested by its owners. High values for this ratio indicate that the company is less likely to require debt or additional equity investments. The return on assets ratio and return on equity ratio are based on accounting book values and not on market values. It is not appropriate to compare these ratios with market rates of return such as the interest rate on Treasury bonds or the return earned on an investment in a stock.
- Profit margin The profit margin ratio is calculated by dividing net income by total sales. This ratio indicates the amount of income that the company earns on each dollar of sales. The trend in this ratio from month to month can show how well the company is managing their operating or overhead costs.
Market ratios relate a market value, the stock price, to values from the company's financial statements.
- Earnings per share The earnings per share ratio is calculated by dividing net income by the number of shares outstanding. A high value in this ratio is very attractive to potential investors.
- Price to earnings To calculate the price to earnings ratio:
- Calculate the earnings per share ratio above.
- Divide your price per share by the value from step 1.
This ratio indicates how much investors are willing to pay per dollar of current earnings. This ratio is not meaningful, however, if the firm has very little or negative earnings.
Debt management ratios attempt to measure the firm's use of debt and its ability to avoid financial distress in the long run.
- Total debt The total debt ratio is calculated by dividing total debt by total assets. A value of less than 1 in this ratio means that the company could not cover all of its debt by selling all of its assets.
- Debt to equity The debt to equity ratio is calculated by dividing total liabilities by owner's equity. This ratio indicates what proportion of the company's assets is financed using debt versus financed using equity supplied by the company's owners. Look for a debt to equity ratio in the range of 1:1 to 4:1.
Compare ratios with industry averages
A presentation that only included ratios would be pretty meaningless. You add value in the way that you analyze the ratios.
A good strategy is to compare the ratios to some sort of benchmark, such as industry averages. For example, you know that a high inventory turnover ratio is generally positive. On the other hand, an unusually high ratio compared with the industry average could mean that the business is losing sales because of inadequate stock on hand.
There are a number of sources for industry figures.
Commercial sources These include private credit reporting agencies such as Dun & Bradstreet and RMA. Rating agencies such as Moody's and Standard & Poor's also provide industry information.
Government sources Examples are the U.S. Industry & Trade Outlook and Quarterly Financial Reports.
Trade associations Many industries have trade associations or industry groups that regularly publish information for and about members.
Compare ratios with competitors' ratios
Ratios are very useful for making comparisons between a company and other companies in the same industry.
Let's look at an example. A gross profit margin of 15% for a company is meaningless by itself. If you know that a company's competitors have profit margins of 25%, you know that company is less profitable than its industry peers. This information might lead you to suggest that the company reconsider its pricing strategy or analyze ways to reduce its cost of goods.
Be careful in any comparison to be certain that you are comparing apples to apples. A cross-industry comparison of the debt of stable utility companies and cyclical mining companies would be meaningless.
Compare ratios over time
Ratios calculated from current financial statements can be compared with those from prior statements to see how a company has changed and to predict how it might perform in the future.
For example, knowing that this year a company has a return on assets of 10% doesn't tell you whether the company is healthy. If you see that this return has been increasing steadily for the last few years, it's a favorable sign that management is implementing effective business policies and strategies.
Consider carefully the appropriate time frame for comparison. Some companies are in businesses with a definite cycle. Examining a company's profitability ratios over less than a full business cycle would not give an accurate long-term measure of profitability.
You need to do some additional research when using historical data to project future trends. Look for any unusual changes within the company that might put these projections into question. For example, the company may have been involved in a merger, or its technology or market position may have significantly changed.
Dive deeper into your analysis
Ratio analysis is based upon financial statement information. Financial statements contain summarized totals of the data supporting the analysis. Therefore, ratio analysis should be used only as a first step in financial analysis, to obtain a quick indication of a firm's performance and to identify areas that need to be investigated further.
Following are examples of the deeper analysis that you can do to better understand any variances from the averages identified by ratio analysis.
Customer profitability analysis
If the profit margin ratio is low in comparison with the industry average, determine whether the company's sales are to a small number of customers or whether the company's customers can be grouped into a small set of groups. If so, consider analyzing sales and operating expenses by customer or customer groups. You can use this analysis to show that the low profit margin can be blamed on too low a sales price for a particular segment of sales.
Inventory cost of goods sold analysis
The inventory turnover ratio uses average inventory. Because it's an average, it assumes that all products are the same, each selling at the same rate, and each costing the same amount. The ratio also assumes that the inventory contains only one product.
If the company's inventory turnover ratio is out of line with competitors or industry standards, determine whether the company's inventory is made up of more than one product. If it is, consider analyzing the inventory by product. Most likely, the company's products have differences, such as that some sell faster while others cost more to purchase.
Product profitability analysis
Product profitability analysis requires you to look at each product or line individually, taking into account the number in inventory during the year and the sales and expenses related to that product.
If the company's inventory turnover ratio is low, this analysis can be used to pinpoint the specific inventory items that are creating an excess investment in inventory.
Conclusions can differ
Financial ratio analysis doesn't involve just comparing different numbers from the balance sheet, income statement, and cash flow statement. It's comparing the numbers against previous years, other companies, the industry, or even the economy in general. It's an excellent method for determining the overall financial condition of a business. Ratios can also help you spot potential threats to company health to help you decide where to dive deeper into the analysis.
Financial ratio analysis is well developed and the actual ratios are well known. Don't assume, however, that the conclusions based on the analysis are cut and dried. Accountants who spend a lot of time doing financial analysis develop their own measures for particular industries and even for individual companies. They often differ drastically in their conclusions from the same ratio analysis.