Week One Lecture
Ratio Analysis
Introduction to Ratio analysis
This week we will explore ratios. Ratio analysis is a very simple, but powerful tool, to help the business manager better understand his or her financial statements. Ratios are simply the comparison of two numbers by dividing or multiplying. This gives more meaning to the underlying data.
Ratios Do Not Define the Problem
Too often people try to force ratios do things they are not designed to do. Ratios do not give you enough information to develop solutions to the problems presented. All the ratios do is provide general information, either positive or negative, about your business.
When it comes to highlighting problems, they act like the idiot lights on your car. If the oil light turns on as you are driving down the street, you do not have a good handle on the problem. All you know is that you have a problem with the oil system. And we all know you ignore the oil light only at your peril. Additional work is needed to define the problem. This is also true with ratios. If you get a falling acid test, (current assets – inventory)/current liabilities, all you understand at this point is that inventory is probably building. Why and how this is occurring is not provided by the ratio. Therefore it is inappropriate to implement a solution based strictly upon the ratio analysis.
Trends vs. Industry Averages
A single ratio is not particularly helpful. It also must be compared with something else to make it meaningful. For example, if you had a profit margin of 15 percent this year, someone might believe that was fine. But if last year’s profit margin was 25 percent, then this year’s profit is actually not good. Trends and comparison of ratios to industry averages are the two typical ways ratios are given more meaning.
Industry Averages
Combining ratios of many companies in the same industry creates industry averages. If your company’s current ratio were above that of your industry average, this would be a positive.
There are many problems with the use of industry averages. I personally use them with caution. But, as the old expression goes: They are better than a sharp stick in the eye!! (That’s a Southernism from my mother’s side of the family)
The data collection methods are primitive, at best. Dunn and Bradstreet is a major source of industry averages. Periodically D&B sends out questionnaires to CFOs throughout the country asking for the financial statements of the company. This information is turned into ratios and averaged. Except for publicly traded companies, there are no quality controls on the accuracy of the information.
If your company was doing very poorly you might have an incentive to not report this information out accurately. And if you were making profits like gangbusters, there is also an incentive to lie. Because most companies are not publicly traded, checking on the truth behind these numbers is almost impossible.
The other problem with industry averages is the fact that they are averages. As such, the results can be misleading. An exaggerated example is shown below with an industry made up of two companies: Alta Ski Resort and Snowbird Ski Resort.
Alta has no long-term debt and Snowbird, which is next door, has huge debt. Their debt ratios (total liabilities/total assets) are shown below. All numbers are made up.
Resort Debt Ratio
Alta 0%
Snowbird 90%
Industry Average 45%
It is obvious from this example, that the industry average is meaningless to either resort. Of course industry averages have more companies than this example, but the problem still remains: averages mask the true nature of the reality simply because they are averages.
Benchmarking Option
If you want to use an industry average approach, the best method is to select a strong competitor or group of competitors and compare your ratios against this group of leaders. The difficulty with this method is lack of data. Finding the data, especially when a corporation has multiple divisions or product lines can make it impossible to get the correct ratios for your particular needs.
Trends
The best analysis of ratios comes from a comparison of your own past trends. A minimum of three periods is needed to create a trend. You should select ratios from the same time frame in past years to avoid seasonality problems. For example, you want to see the profit margin trend for the three quarters. Since it is now the third quarter in the fiscal year, you would want to select profit margins for the third quarter in each of the past two years to compare with the current data.
Typical Categories of Ratios
There are many ways to categorize ratios. Categories are created solely to help the student remember the ratios. The groups shown below are simply my own variation. These are the ratios you will be expected to know for the first exam. There are many other ratios in the text. All of the ratios listed in the text and listed here should be calculated and analyzed for your team case.
Category Ratios Formula
Profitability Gross Profit Margin Gross Profit/Sales
Operating Profit Margin Net Operating Income/Sales
Profit Margin Net Income/Sales
Asset Performance Return on Assets Net Income/Total Assets
Debt Ratio Debt Ratio Total Liabilities/Total Assets
Liquidity Current Ratio Current Assets/Current Liabilities
Acid Test (or quick ratio) (Curr Assets-Inventory)/Curr Liab
Average Collection Period Accts Receivable/(sales/365)*
(or Days Sales Outstanding)
*Sales are “credit sales” rather than cash sales. Unless indicated otherwise, you can normally assume all sales in this course are credit sales.
Except for the current ratio, there are no “right” numbers. The trend is what counts. The current ratio should always be above 1X (1 time). Any time it approaches 1X, it is a red flag. Why? Because the company is about to be unable to pay off its current obligations with its most liquid assets (current assets)
The acid test removes one of the “accounting fictions” from the liquidity calculation. Inventory is really not very liquid. By removing this number, especially with firms that have large inventory, you get down to the real liquidity picture. Normally, a dropping acid test implies an increase in inventory.
The average collection period is expressed as the number of days it takes on average to collect receivables. Obviously increased days means a reduction in cash since more money is tied up in receivables. You cannot assume that 30 days is the normal collection period for every industry. For example, companies that rely on medical insurance payments (e.g. hospitals, ambulance companies, etc) will see normal average collection periods well above 100 days. It takes that long for the average insurance claim to be paid.
The debt ratio is the basic leverage calculation. It is expressed as a percentage. If it were 90 percent, it means $9 out of $10 of your company’s assets are funded with debt (that would be considered highly leveraged in anyone’s book).
Profitability ratios focus on the income statement. The return on asset ratio combines the income statement and balance sheet. A major red flag occurs when a company is losing money (or becoming less profitable) from operations and is getting more profitable when you look at net income after taxes (i.e. add in the impact of the non-operations part of the firm).
Normally everything that turns the profit margin picture around in the non-operating side of the ledger has major downsides. For example, if the interest earnings on investment are covering losses on operations, the implication is that the treasurer is taking increased risks to generate higher investment returns.
Most Important Ratios
The liquidity ratios are the most important. If you cannot stay liquid, you cannot stay in business. If you can stay liquid, profits will come. There is an expression that says it all: “Cash is King”.
In the boom time period of the 1990s it became popular to work with as small cash balances as possible. The theory was straightforward: excess cash should get a bigger return than the local bank certificate of deposit. Companies boasted about how low their cash balances were.
This foolish theory has been clearly shown to be bankrupt. The companies that survive downturns are those who have strong balance sheets. An important part of a strong balance sheet is a solid cash position.
You cannot ignore the other ratios. Once you have good liquidity, asset performance and profitability must become your focus.
Pull A Complete Set of Ratios; See the Plot Lines Develop
It is important to pull a full set of ratios. This will provide a complete picture. Information will come to the surface that otherwise would remain hidden without calculating all the ratios.
The “good, bad, and the ugly” start to surface when a number of ratios are calculated. No company is all bad or all good. The full set of ratios tells multiple stories. Look for central plots, but do not miss the many subplots that ratios uncover.
Suggestions for Conducting Ratio Analysis
Start with sales. Sales growth rates, or lack thereof, set the tone for the entire company. When sales are down, cash flow is critical. When sales are rapidly expanding, managing inventory and accounts receivable is critical.
Pull a full set of ratios and look for the plot lines to develop. Do not be surprised by contradictory results. For example, in a rapidly growing firm, good profits and poor liquidity are not uncommon.
Fine-tune your analysis by looking at the relative changes of ratios. An example is shown below:
Ratio Year 1 Year 2 Year 3
Operating Margin 33% 25% 19%
Profit Margin 10% 9% 8%
Both ratios are falling. But to tease out one of the underlying problems, you need to compare the relative rates of change of each ratio.
The operating margin, that is the ratio associated with company operations, went from 33% to 19%. It dropped 42% (33-19=14 and 14/33=42%) over the three-year period. The profit margin that includes both operations and non-operations fell 20% during the same period (10-8 = 2 and 2/10 = 20%).
The underlying problem can now be seen. Since the profit margin did not fall as fast as the operating margin, the difference was made up within the non-operating part of the income statement. You do not know how this was done at this point. But you do know that almost everything that increases profitability in the non-operating area has potential problems. Either higher risk or one-time sources of revenue are typically involved. By comparing the relative changes of ratios you can often develop additional information.
Finally, create a list of questions and areas to follow-up, based upon the results of your ratio calculations. Remember, the goal of ratio analysis is to focus your attention on potential problem areas. This is the first step in defining the problems. It is important to not jump to conclusions at this point. More work is needed before solutions can be considered. For example, if the acid test is falling, you can conclude that inventory is building. But you cannot determine why this is happening. More research is needed.
Another Income Statement Analytical Approach: Percent of Sales
Another analytical approach to ratio analysis of the income statement is to do a percent of sales analysis of the income statement. If done correctly this will provide additional information on trends in costs of goods and overhead expenses.
We do not need to see the actual financial statements to answer the following questions. What is happening to Cost of Goods Sold? What is happening to overhead expenses? How are non-operating revenues and expenses impacting the company’s bottom line? To do this analysis one simply converts income statement ratios to a percent of sales. An illustration of this process is shown below.
Let’s assume the following income statement ratios have been calculated for Widget Corp:
Year 1 Year 2 Year 3
Gross Profit Margin 35% 37% 41%
Operating Margin 17% 16% 15%
Profit Margin 7% 7% 7%
Step 1: Analyze Cost of Goods Trend using the Gross Profit Margin
The gross profit margin formula is gross profit / sales. If the year one gross profit margin is 35 percent that means that for each dollar of sales 35 cents is gross profit. This can be seen by assuming sales of one dollar. If you enter this information into the formula for gross profit as shown below you will see that the gross profit must be 35 cents.
Gross Profit / 1 dollar = 35%
Gross profit = 1 dollar X 35%
Gross profit = 35 cents
Using this approach we will convert the gross profit margin results into pennies per one dollar of sales.
Year 1 Year 2 Year 3
Sales $1.00 $1.00 $1.00
Gross Profit $ .35 $ .37 $ .41
Now we will calculate the cost of goods for each dollar of sales.
Year 1 Year 2 Year 3
Sales $1.00 $1.00 $1.00
COGS .65 .63 .59
------
Gross Profit .35 .37 .41
It is clear from this analysis that cost of goods are dropping on a per dollar of sales basis. This is very useful to understand. You can then focus on asking the right questions such as what specific things is management doing to get the cost of goods to fall? Are there long term negative consequences to this trend?
Step 2: Analyze Overhead Expenses using Operating Margin
Once you have the gross profit calculated as a percent of sales or pennies per one dollar of sales you can then analyze the trend of overhead expenses. Use the operating margin ratio and adjust it to a one dollar of sales basis (just as was done with the gross profit analysis above). The formula for operating margin is net operating income or EBIT / sales. This is shown below, using the ratios from the beginning of this section.
Year 1 Year 2 Year 3
Sales $1.00 $1.00 $1.00
Net Operating Income $ .17 $ .16 $ .15
Now we can add the net operating income (which is expressed as pennies per dollar of sales) to the income statement and calculate the overhead expenses as a percentage of sales. Please note the gross profit must first be calculated in order to do this analysis. You calculate the overhead expense by subtracting the EBIT or net operating income from the gross profit. This will give you overhead on a pennies per dollar of sales basis.
Year 1 Year 2 Year 3
Sales $1.00 $1.00 $1.00
COGS .65 .63 .59
------
Gross Profit .35 .37 .41
Overhead Expense .18 .21 .26
------
Net Operating Income $ .17 $ .16 $ .15
As can be readily seen, overhead is growing fairly quickly. And a good manager can now focus on what particular areas of overhead are causing this growth. A good starting point is to convert all line items in the overhead area to a percent of actual sales. Any that show significant growth trends need to be closely examined.
At this point it is clear that Widget Corp has been able to reduce its cost of goods significantly but it has an overhead growth problem. Next we will examine the impact non-operating revenue or expenses are having on the company’s bottom line.
Step 3 Analyze the Non-operating Impact on the Profit Margin.
The non-operating part of the income statement includes non-operating revenue (such as one time sale of assets, interest earning on investments), non-operating expenses (such as interest expense on debt), and corporate income taxes. We would like to understand if the non-operating items are helping or hurting the company’s bottom line. The use of percent of sales analysis which we have previously done for the cost of goods and overhead expenses is also useful here.
We will use the same process to convert the profit margin (net income after taxes / sales) to net income per one dollar of sales. This is shown below, using the data from the beginning of this section.
Year 1 Year 2 Year 3
Sales $1.00 $1.00 $1.00
Net Income after Taxes $ .07 $ .07 $ .07
At this point it is interesting to note that the bottom line profit has remained steady for the past three years. We want to know what impact the non-operating part of the income statement is having on the company’s financial picture. So we do the same calculations we have previously done for the cost of goods and overhead expense section. Remember you must have done the overhead calculation first in order to complete this part of the analysis.
Using the data from above:
Year 1 Year 2 Year 3
Sales $1.00 $1.00 $1.00
COGS .65 .63 .59
------
Gross Profit .35 .37 .41
Overhead Expense .18 .21 .26
------
Net Operating Income $ .17 $ .16 $ .15
Non Operating Impact .10 .09 .08
------
Net Income after Taxes $.07 $.07 $.07