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.