Various ratios are used to help interpret and understand financial statements. These ratios are guides to understanding changes in financial performance for one company from year to year and differences in financial performance between two or more companies. Ratios are most useful when comparisons are made, either between time periods or among different companies. Ratios are useful shortcuts that permit the analyst to collapse the myriad details in financial statements into a few simple numbers. But remember that the ratio calculations are not the answers; they just show relationships. The analyst or manager must understand those relationships and make decisions on the basis of a host of information.
Ratios are just one input to those decisions. In other words, ratios are one indicator of financial health and viability, but they do not tell the whole story. Users of financial statements must be careful not to become too enamored of the ratios themselves and should not forget to look for other indicators that will permit better decision making. Also, ratios are historical. Judgment is needed to use them for decision making because future conditions may change. Bear in mind that ratios are only as good as the data that comprise them. The discussions in later chapters will help you be aware of differences in accounting policies that can cause differences in ratios.
Balance sheet ratios aid the analyst in assessing a firm’s liquidity, asset management, and debt management policies, each of which is discussed in the following sections.
- Vertical Analysis
- Liquidity Ratios
- Asset Management Ratios
- Debt Management Ratios
- Limitations of Balance Sheet Analysis
Analysts usually begin with a review of the firm’s assets, as well as its liabilities and owners’ equity. This review begins with the preparation of a common-size balance sheet, which shows the percentage component of each major section to the grand totals on each side of the balance sheet. This analysis is called vertical analysis.
Liquidity represents the ability of a company to convert its assets to cash, and liquidity ratios are often calculated from balance sheet data. Although there are many types of liquidity ratios, we focus here on a few of the more basic ones.
The most popular liquidity ratio is the current ratio. The current ratio is calculated by dividing all current assets by all current liabilities:
Current ratio = Current assets / Current liabilities
Current ratios that represent good liquidity and financial health vary widely across firms and industries. Currently, many companies have a current ratio between 1.3 and 1.5. Many companies have short-term lines of credit and other borrowing capacities that permit them to operate with a nearly balanced amount of current assets and current liabilities. In any event, the analyst would be worried to find current liabilities substantially in excess of current assets (in other words, when the current ratio is considerably less than 1). Declining trends in the current ratio would also cause concern, especially in conjunction with declining trends in other ratios.
Another major liquidity ratio is the quick ratio, which is often called the acid test. In this context, “quick”means close to cash. To calculate this ratio, cash and receivables are added and then divided by all current liabilities. In computing the quick ratio, the net realizable value of the accounts receivable should be used.
The purpose of the quick ratio is to indicate the resources that may be available quickly, in the short term, for repaying the current liabilities. For this reason, inventory and prepaid expenses are left out. In other words, the quick ratio is a type of “disaster” ratio that is used to indicate a worst case scenario that might apply if no other resources are available to pay the current liabilities that are due within the next year.
Quick ratio = (Cash + Receivables) / Current liabilities
Values for the quick ratio are often less than 1.0, and a rule of thumb used by some analysts is that the quick ratio should not be less than .30. Again, declining trends should cause the most concern. When comparing two companies, a lower quick ratio and a lower current ratio do not, in and of themselves, indicate that the company with the lower values is in worse financial condition. Lower liquidity may be offset by a variety of other financial indicators, such that the company with lower liquidity ratios could still rank higher on its overall financial stability and financial health.
Asset Management Ratios
Asset management ratios focus on the composition of the firm’s assets and on changes in the composition of assets over time (changes between successive balance sheets). A vertical analysis of the left side of the balance sheet allows the analyst to examine the percentages of the total assets devoted to each category. This examination gives some indication of the resources used for current assets relative to those used to provide operating capacity.
In reviewing the percentage composition of a firm’s assets, the analyst keeps several factors in mind. First, to a large extent, the composition of assets depends on the industry in which the firm operates. In some cases, comparisons between industries may be meaningless. “Smokestack” industries, for example, such as metal fabrication, require large investments in factory buildings and heavy equipment, such that a major portion of these firms’ assets are noncurrent. On the other hand, merchandising industries, such as department stores, require large amounts of accounts receivable and also substantial investments in inventories available for resale, but relatively minor investment in buildings and equipment. Financial firms such as banks and insurance companies have relatively little in the way of inventories, factory buildings, and equipment. Instead, the assets of financial firms consist mainly of loans receivable and investments in securities (stocks and bonds) of other firms. A first step for the analyst in assessing a firm’s asset composition is to be aware of any peculiar industry norms or special circumstances.
In addition to industry characteristics, the analyst knows that managers may have sound business reasons for structuring a firm’s assets differently than those of its competitors. For example, some managers may extend liberal credit terms to customers as a way of improving sales and, as a result, may have a large accounts receivable balance. Other managers may carry large inventories for customer convenience or may stockpile inventories in anticipation of rising price or supply bottlenecks. On the other hand, large amounts of accounts receivable may indicate that a firm has difficulty collecting its accounts. Similarly, large inventories may reflect obsolete items or declining product sales. In short, increases or decreases in specific components of a firm’s total assets may be either good news or bad news. Any ratio computations are only the first step for the analyst. The creative art in ratio analysis is understanding the reasons for ratio differences among firms and over time.
Debt Management Ratios
The most inclusive and most useful debt management ratios are the composition ratios drawn from a vertical analysis of the right side of the balance sheet. These percentage composition ratios indicate the relative proportions of various forms of debt and owners’equity used to finance the organization. The vertical analysis of Sample Company’s sources of funds shows that 33.8% of all financing came from current liabilities. A smaller amount (24.4%) came from longterm liabilities, and the largest portion (41.8%) came from owners. Of the 41.8% portion that came from owners, 29.3% was in the form of direct investment, and 12.5% was in the form of profits reinvested in the business.
The fact that Sample Company’s owners’ equity provides 41.8% of the firm’s resources suggests that the owners’ equity of this firm offers substantial protection to lenders. Suppose, for example, Sample Company was unable to continue its operations and had to liquidate its assets, or, in other words, convert its assets to cash. In such a situation, Sample Company could incur losses of 41.8% of the assets’ carrying value, and the cash received would still be sufficient to pay off all the firm’s debts. Of course, nothing would then be left for the owners.
Limitations of Balance Sheet Analysis
Although the ratios reviewed in this section provide a useful starting point for assessing a firm’s financial management policies, several limitations must be considered. First, ratio calculations are only the initial step in analyzing a firm’s condition. They merely provide the analyst with a point of departure for asking further questions. Second, individual financial statements such as the balance sheet are seldom analyzed separately from other statements described in the next two chapters. In fact, many of the most useful ratios used by analysts measure relationships among financial statements, rather than relationships within a single financial statement. For this reason, we will expand and enrich our study of ratio analysis after first describing the other primary financial statements. Third, information useful for analyzing and clarifying financial statements is contained in other parts of a company’s financial reports.
An important limitation in comparing financial ratios across firms is the fact that their accounting methods may differ. Later chapters discuss the varieties of different methods that firms may use in measuring assets, liabilities, shareholders’ equity, revenues, and expenses. For now, be aware that financial ratios may be significantly affected by alternative accounting methods. The analyst attempts to adjust for differences caused by accounting methods in order to make valid ratio comparisons among different firms. The notes to the financial statements alert the analyst to the principal methods being used.