Ratio Analysis

Understanding business health through liquidity and leverage ratio analysis

Lesson Overview

Instructor Presentation

Introduction

Ratio analysis represents one the most mathematically straightforward and most important analysis concepts that Business, Finance and Accounting students should know.  Ratio analysis is used by business in contexts of both internal and external exercises.  The basis for the analysis always begins with the financial statements for the business.  Two ideas should be stressed.  First, even amongst business of similar nature and industry, variations in accounting techniques do exist and therefore, care should be taken in relying exclusively on the results of ratio analysis.  Second, when using financial statements, the more current the statement the more accurately we can make conclusions.

Goals

Students will be able to identify the basic categories of ratio analysis and where this type of analysis could be used appropriately.

Students will be able to calculate appropriate ratios.

Students will be able to describe business improvements that could effect the ratios being investigated.

Notes

Ratio analysis is one of the first steps in most processes.  Ratios are used to give us a generalized indication of the health of a business.  Ratio analysis should be used as a part of the evaluation process, not as the sole set in the evaluation process.
Ratios analysis is based on the reported financial statements of businesses.   We use industry financial data within this lesson plan with permission from Risk Management Associates.
This notebook is part one of a three part series on Ratio Analysis.

Concept Exploration

Basic Categories of Ratio Analysis

Business are compared and evaluated for many different reasons and in many different ways.  The two primary ways are through Trend Analysis and through Ratio Analysis.  Trend Analysis is used to measure year to year within the business.  This lesson covers Ratio Analysis; the analysis of the performance of business against other businesses in it's industry.
First of all realize that not all ratios are created equal.  Most people, depending on their focus, are only concerned with a few of the different ratios.  Ratios can be categorized as:

Liquidity Ratios

Leverage Ratios

Operational Ratios

Profitability Ratios

Market Value Ratios

Financial ratio analysis groups the ratios into categories which tell us about different facets of a company's finances and operations.  An overview of some of the categories of ratios is given below.
·

Further Exploration

Defining Basic Purposes for Ratio Use

Depending on the goal of the financial analysis, different ratio categories may be used.  Here is a simple overview of some common ratio categories.

Liquidity Ratios

Liquidity rations are also known as Short term Solvency ratios.  These ratios are important when cash reserves are important, when payments are expected, and for industries that use cash in many transactions.  This ratio category tell people about the capability of the company to pay near term payment requirements.

Leverage Ratios

Leverage Ratios are also know as Debt Management ratios.  These ratios are important to people who are offering the business loans and for people interested in investing in the company.  This ratio informs people about how well the business controls its outstanding debt.

Operational Ratios

Firms use their assets to generate revenue.  A business may buy machines to increase production or they may retain cash for short term obligations.  The decisions that the business managers make determine how much revenue is generated.  This ratio category helps us understand Management decisions and asset balance decisions.

Profitability Ratios

Investors and owners are very interested in getting a return on the money they have invested in the business.  Therefore, Profitability Ratios have been developed to monitor how likely an investment will pay its owners back.

Market Value Ratios

Market Value Ratios deal with publicly traded businesses and deal with the trading price of the stock and its underlying value.

Deeper Exploration

Liquidity Ratios

Lets look at couple of the Ratios that are included in this category.

Current Ratio -  Measures a company's ability to pay its bills.

Current Ratio =  ((Current Assets)/(Current Liabilites))

Quick Ratio(Acid-Test Ratio) - A more stringent test of a company's ability to pay its bills.

Acid-test Ratio =  ((Cash + Accounts Receivable)/(Current Liabilities))

Examples

1.  Liquidity Ratios - Examples

1.1  Calculate the Current Ratio for the Johnson Company which has the following Current Assets and Current Liabilities:

Current Assets - $153,250   and  Current Liabilities  - $66,700

1.2  Calculate the Current Ratio and the Acid-Test Ratio for the Bonneville Company which has the following Current Assets and Current Liabilities:

Cash - $85,000  ,  Accounts Receivable - $60,000  ,  Inventory - $93,500   and  Current Liabilities  - $66,700

1.3  If Current Ratio for the Bonneville Company is 1.36 and the Acid-Test Ratio is 0.83.   What might you recommend the Bonneville Company do?

Deeper Exploration

Leverage Ratios

Debt to Equity Ratio -  Measures how a company has raised money.   Ratios near the value of 0, indicate that the company has little debt.  Ratios greater than 1.0 indicate that more money has been raised through loans as opposed to via owner equity.

Debt to Equity Ratio =  (Debt/(Owners Equity))

Debt Ratio -  Measures whether a company has assets to cover existing debt levels.

Debt Ratio =  ((Total Liabilities)/(Total Assets))

Examples

2.  Leverage Ratios - Examples

2.1  Calculate the Debt to Equity Ratio for the Williams Company given the following:

Debt - $1,358,000   and  Equity - $3,405,500

2.2  Banks tend to refuse loans when debt to equity ratios are above a certain rate.  If the Williams Company has $550,000 in owners equity, what is the maximum amount of money that The First Bank will loan the Williams Company, if The First Bank's threshold is 70%:

2.3  Calculate the Debt Ratio for BBB Office Supply, Inc given:

Total Liabilities - $19,000  , Cash - $12,000 , Accounts Receivable - $45,000 , Plant and Equipment - $150,000, Accumulated Depreciation - $146,000.

2.4  Use the Interactive Demonstration below to determine the BBB Office Supply, Inc  Debt to Equity Ratio and Debt Ratio with the information given:

BBB Debt - $450,000 , Total Liabilities - $600,000 , Owners Equity - $250,000 and Total Assets - $850,000

BBB Debt - $150,000 , Total Liabilities - $230,000 , Owners Equity - $450,000 and Total Assets - $680,000

Manipulate[
Module[{displaytab},
industry=Switch[naics,1,industry532291,2,industry532210,3,industry532120,4,industry532111];
debttoequity=N[debt/equity,3];
debtratio=N[liabilities/assets,3];
industrydebttoequity=N[(100-industry[[2,9]])/100,3];
industrydebtratio=N[((industry[[2,2]]+industry[[2,6]])/industry[[2,9]]),3];

(* create table for displaying Operational Ratios *)
displaytab = {{"Debt To Equity Ratio",debttoequity,industrydebttoequity},{"Debt Ratio",debtratio,industrydebtratio}};

(* Set up display Panes *)	
  Pane[

(*Add headers to data tables.  Add frames and spacing. *)
Text@Grid[Join[{{"Financial Ratios : Leverage Ratios",SpanFromLeft},{"Parameter","Value", "Average"}}, displaytab],
			Dividers->{{True, True, True,True,True}, {True,True,True, True,True}},
			Spacings->{Automatic,0.6},ItemSize->6
],  

ImageSize->{400,400},Alignment->{Center,Center}]
],

(*Create the left hand data entry area of the display *)
(* Text[" "]  used for vertical spacing *)
Text[Style["LEVERAGE RATIOS",Large,Bold,Red]],Text[" "],
Text[Style["INDUSTRY",Medium,Bold,Blue]],
Text[Style["Select the NAICS Industry Code",Medium]],
{{naics,1,"NAICS Code:"},{4->Tooltip[532111,Passenger Car Rental],2->Tooltip[532210, Computer Rentals],1->Tooltip[532291,Home Health Equip Rentals],3->Tooltip[533120,RV Rentals]},ControlType->Setter},
Text[""],
Delimiter,
Text[Style["ASSETS",Medium,Bold,Blue]],
Text[Style["Enter values from Balance Sheet",Medium]],
Text[""],
{{assets, 300, "Total Assets ($K)"}, 100, 1000,10, Appearance -> "Labeled",ImageSize->Small},
Text[""],
	Delimiter,
Text[Style["LIABILITIES",Medium,Bold,Blue]],
Text[Style["Enter Values from Balance Sheet",Medium]],
Text[""],
{{debt, 300, "Debt($K)"}, 10, 1000, 10, Appearance -> "Labeled",ImageSize->Small},
{{liabilities, 500, "Total Liabilities ($K)"}, 100, 1000, 10, Appearance -> "Labeled",ImageSize->Small},
{{equity, 500,"Owners Equity ($K)"},100,1000,10, Appearance -> "Labeled", ImageSize->Small},

	ControlPlacement -> Left,
	SaveDefinitions -> True,
	TrackedSymbols -> True
]

Examples Answer Key

1.  Liquidity Ratios - Examples

1.1  Calculate the Current Ratio for the Johnson Company which has the following Current Assets and Current Liabilities:

Current Assets - $153,250   and  Current Liabilities  - $66,700

assets=153250; liabilities=66700;currentratio =N[ assets/liabilities,3]

The current ratio is 2.30.

1.2  Calculate the Current Ratio and the Acid-Test Ratio for the Bonneville Company which has the following Current Assets and Current Liabilities:

Cash - $85,000  ,  Accounts Receivable - $60,000  ,  Inventory - $93,500   and  Current Liabilities  - $66,700

cash=85000; ar=60000;invent=93500;liabilities=66700;currentratio=N[(cash+ar+invent)/liabilities,3]
acidtest=N[(cash+ar)/liabilities,3]

Current Ratio = 3.58
Acid-Test Ratio = 2.17

1.3  If Current Ratio for the Bonneville Company is 1.36 and the Acid-Test Ratio is 0.83.   What might you recommend the Bonneville Company do?

The Acid-Test ratio tells me they don't have enough cash to pay for the current liabilities.  I might recommend that Bonneville Co look over it inventory and purchasing process to see if reductions in inventory can be made allowing them to increase their cash position.

2.  Leverage Ratios - Examples

2.1  Calculate the Debt to Equity Ratio for the Williams Company given the following:

Debt - $1,358,000   and  Equity - $3,405,500

debt=1358000;equity=3405500;debttoequity=N[debt/equity,3]

The Debt to Equity ratio is .399 or 39.9%.

2.2  Banks tend to refuse loans when debt to equity ratios are above a certain rate.  If the Williams Company has $550,000 in owners equity, what is the maximum amount of money that The First Bank will loan the Williams Company, if The First Bank's threshold is 70%:

equity=550000;maxdebttoequityratio=0.7;threshold=N[equity*maxdebttoequityratio,2]

Since the Debt / Equity ratio of 0.70 is the max allowed and there is $550,000 in equity.  
Debt/Equity Ratio =   (Debt/Equity)
0.70 = (Debt/550000)
550000 * 0.70 = Debt
So the maximum Debt threshold that First Bank will loan is $385,000.

2.3  Calculate the Debt Ratio for BBB Office Supply, Inc given:

Total Liabilities - $19,000  , Cash - $12,000 , Accounts Receivable - $45,000 , Plant and Equipment - $150,000, Accumulated Depreciation - $146,000.

liabilities=19000;assets=12000+45000+(150000-146000);debtratio=N[liabilities/assets,3]

The Debt Ratio of BBB Office Supply is .311.

Initializations

Data found below are copyrighted by Risk Management Associates, Financial Statement Studies: Financial Ratio Benchmarks, 2008-2009.  Permission given to author for non-commercial use in this demonstration.

industry532291={{13.0,22.2,5.5,2.9,40.9,7.6,8.0},{9.8,9.6,8.5,0.1,10.4,29.4,0.6,3.7,27.9},{100,0.0,84.8,3.5},{{1.9,1.1,0.6},{1.4,0.9,0.5},{238.9,7.1,4.9},{2.4,1.6,1.0},{0.7,2.2,-21.8},{0.9,2.8,-63.1}}};

industry532210= {{7.7,12.5,15.9,4.3,46.1,4.9,8.6},{17.1,8.2,9.0,0.1,7.0,30.5,0.5,9.5,18.0},{100,0.0,89.3,6.4},{{2.1,1.0,0.3},{1.4,0.4,0.1},{500,57.6,12.6},{2.3,1.5,0.7},{0.5,4.1,-16.0},{1.5,6.2,-23.3}}};

industry532120={{7.5,10.5,7.8,4.1,61.8,1.7,6.5},{11.4,11.7,4.5,0.3,6.0,38.0,2.0,3.9,22.2},{100,0.0,86.6,5.8},{{1.6,0.9,0.4},{1.1,0.5,0.2},{183.2,12.9,8.2},{1.6,0.8,0.4},{1.3,2.7,7.3},{1.8,3.6,10.2}}};

industry532111={{6.8,4.6,17.8,8.1,53.5,3.2,5.9},{34.9,6.1,3.9,0.2,5.9,26.2,0.7,4.5,17.5},{100,0.0,91.9,6.8},{{1.2,0.7,0.2},{0.5,0.2,0.1},{90.4,28.9,14.7},{1.1,0.7,0.5},{0.3,3.2,11.1},{2.4,6.1,17.3}}};