Ratio Analysis

Understanding business health through operational and profitability ratios

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 two 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.
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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

Operational Ratios

Inventory Turnover -  Measures how many times per year the value of inventory is sold. This is a measure of how well management knows the demands of their customers and how well they execute supplier contracts.

Inventory Turnover =  ((Cost of Goods Sold)/(Average Inventory))

Receivables turnover shows how quickly a firm collects its trade receivables and hence how good it is at collecting customer debts.  This is a measure that tells how effective management is at affecting cash flow from receivables

Receivables Turnover =  ((Annual Sales)/(Trade Receivables))

Examples

3. Operational Ratios - Examples

3.1  Calculate the Inventory Turnover ratio for the Halifax Group, Inc based on:

Cost of Goods Sold - $1,358,000   and Average Inventory  - $405,500

3.2  Calculate the Receivables Turnover for the Johnson Company if annual sales is $2.4M and the are maintaining a receivable ledger of $750,000:

3.3  You have been asked to comment on how to quickly increase your Receivables Turnover Ratio.  What would you suggest the company do?:

Deeper Exploration

Profitability Ratios

Profit Margin, before tax  measures the efficiency of the business to turn sales dollars into net income.

Profit Margin =  ((Net Income)/(Net Sales))

Return on Equity is a measure of profitability to the business owners as a percent of the moneys invested.

Return on Equity =  ((Net income - Taxes)/Equity)

Examples

4. Profitability Ratios - Examples

4.1  Calculate the Profit Margin ratio for the Talley Games, Inc based on:

Net Sales - $350,000   and  Net Income  - $105,500

4.2  Calculate the Return on Equity for:

Money invested in the company - $500,000 , Taxes paid this year - $25,000 and Net Income - $130,000

4.3  Profit margin looks at Net Income before taxes and Return on Equity involves Net Income after taxes are paid.  Why would owners be more interested in the Return on Equity Ratio?:

3. Operational Ratios - Examples

3.1  Calculate the Inventory Turnover ratio for the Halifax Group, Inc based on:

Cost of Goods Sold - $1,358,000   and Average Inventory  - $405,500

cogs=1358000;invent=405500;inventoryturns=N[cogs/invent,3]

Halifax turns their inventory 3.35 times per year.

3.2  Calculate the Receivables Turnover for the Johnson Company if annual sales is $2.4M and the are maintaining a receivable ledger of $750,000:

revenue=2400000;ar=750000;receivablesturnover=N[revenue/ar,3]

The Johnson Company is collecting its receivables on average 3.2 times per year.

3.3  You have been asked to comment on how to quickly increase your Receivables Turnover Ratio.  What would you suggest the company do?:

Since Receivables Turnover is sales divided by Accounts Receivables we can only effect change through these two factors.  Sales could be changed by discounting prices to move more product, by traditionally sales provides slow changes.  The quickest way is to increase the level of receivables being collected.  Look at all sales at or beyond your credit term and begin credit calls to obtain payment.

4. Profitability Ratios - Examples

4.1  Calculate the Profit Margin ratio for the Talley Games, Inc based on:

Net Sales - $350,000   and  Net Income  - $105,500

netincome=105000;netsales=350000;profitmargin=N[netincome/netsales,3]

The Profit Margin for Talley Games is 0.30  or a 30% profit margin.

4.2  Calculate the Return on Equity for:

Money invested in the company - $500,000 , Taxes paid this year - $25,000 and Net Income - $130,000

netincome=130000;taxes=25000;equity=500000;returnonequity=N[(netincome-taxes)/equity,3]

There is a 21% return on equity for this company.

4.3  Profit margin looks at Net Income before taxes and Return on Equity involves Net Income after taxes are paid.  Why would owners be more interested in the Return on Equity Ratio?:

Since owners are principally interested in getting a return on their money the most direct measure for money they will receive will be the most important.  Information given as Profit Margin is nice to know, but the relationship between the investors money invested and the revenue is a bit foggy.  If you tell an investor that they will get a 21% return on their equity, they know exactly what to expect.

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}}};