Wk 4 - Signature Assignment: Financial Performance Calculations

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Financial Ratio Analysis Tutorial

Business owners tend to dislike the Dnancial management of their Drm. Who can

blame them!? It certainly isn't as fun as marketing or advertising or developing an e-

commerce site. But, there is one thing about learning about the Dnancial

management of your business Drm. It is absolutely necessary. So, you gotta suck it up

and learn it. This Drst Dnancial ratio analysis tutorial, the Drst in a series of tutorials on

Dnancial ratio analysis I'm writing, will get you started.

This tutorial is going to teach you to do a cursory Dnancial ratio analysis of your

company with only 13 ratios. Yes, with only 13 Dnancial ratios, you can get a pretty

good idea of where your company stands. Of course, you need either past Dnancial

statements to compare your current Dnancial statements against or you need

industry data. In this tutorial, I'll use past Dnancial statements and do a time-series

analysis. Maybe in another tutorial, I'll show you how to do a cross-sectional with

industry Dnancial ratio analysis.

Here is the

balance sheet

we are going to

use for our

Dnancial ratio

tutorial. You will

notice there are

two years of

data for this

company so we

can do a time-

series (or trend)

analysis and see

how the Drm is

doing across

time.

Here is the

complete

income

statement for

the Drm for

which we are

doing Dnancial

ratio analysis.

We are doing two

years of Dnancial

ratio analysis for

the Drm so we

can compare

them. Refer back

to the income

statement and

balance sheet as

you work

through the

tutorial.

The Drst ratios I recommend analyzing to start getting a Dnancial picture of

your Drm measure your liquidity or your ability to convert your current assets to

cash quickly. They are two of the thirteen ratios. Let's look at the current ratio

and the quick (acid-test) ratio.

The Current Ratio The current ratio measures how many times you can cover your current liabilities.

The quick ratio measures how many times you can cover your current liabilities

without selling any inventory and so is a more stringent measure of liquidity.

Remember that we are doing a time series analysis, so we will be calculating the

ratios for each year.

Current RatioCurrent Ratio: For 2010, take the Total Current Assets and divide them by the Total

Current Liabilities. You will have: Current Ratio = 642/543 = 1.18X. This means that

the company can pay for its current liabilities 1.18 times over. Practice calculating the

current ratio for 2011.

Your answer for 2011 should be 1.54X. A quick analysis of the current ratio will tell you

that the company's liquidity has gotten just a little bit better between 2010 and 2011

since it rose from 1.18X to 1.54X.

The Quick Ratio Quick Ratio: In order to calculate the quick ratio, take the Total Current Ratio for 2010

and subtract out Inventory. Divide the result by Total Current Liabilities. You will have:

Quick Ratio = 642-393/543 = 0.46X. For 2011, the answer is 0.52X.

Like the current ratio, the quick ratio is rising and is a little better in 2011 than in 2010.

The Drm's liquidity is getting a little better. The problem for this company, however, is

that they have to sell inventory in order to pay their short-term liabilities and that is

not a good position for any Drm to be in. This is true in both 2010 and 2011.

This Drm has two sources of current liabilities - accounts payable and notes payable.

They have bills that they owe to their suppliers (accounts payable) plus they

apparently have a bank loan or a loan from some alternative source of Dnancing. We

don't know how often they have to make a payment on the note.

Asset management ratios are the next group of Dnancial ratios that should be

analyzed. They tell the business owner how eiciently they employ their assets

to generate sales. Assume ALL sales are on credit.

Receivables Turnover

Receivables Turnover = Credit Sales/Accounts Receivable = ___ X so:

Receivables Turnover = 2,311/165 = 14X

A receivables turnover of 14X in 2010 means that all accounts receivable are cleaned

up (paid ok) 14 times during the 2010 year. For 2011, the receivables turnover is 15.2.

Look at 2010 and 2011 Sales in Step 3, The Income Statement and Step 2, The

Balance Sheet.

The receivables turnover is rising from 2010 to 2011. We can't tell if this is good or

bad. We would really need to know what type of industry this Drm is in and get some

industry data to compare to.

Customers paying ok receivables is, of course, good. But, if the receivables turnover

is way above the industry's, then the Drm's credit policy may be too restrictive.

Average Collection Period Average collection period is also about accounts receivable. It is the number of days,

on average, that it takes a Drm's customers to pay their credit accounts. Together

with receivables turnover, average collection helps the Drm develop its credit and

collections policy.

Average Collection Period = Accounts Receivable/Average Daily Credit Sales*

*To arrive at average daily credit sales, take credit sales and divide by 360

For 2010:

Average Collection Period = $165/2311/360 = $165/6.42 = 26 days

In 2011, the average collection period is 23.5 days

From 2010 to 2011, the average collection period is dropping. In other words,

customers are paying their bills more quickly. Compare that to the receivables

turnover ratio. Receivables turnover is rising and average collection period is falling.

This makes sense because customers are paying their bills faster. The company

needs to compare these two ratios to industry averages. In addition, the company

should take a look at its credit and collections policy to be sure they are not too

restrictive. Take a look at the image above and you can see where the numbers came

from on the balance sheets and income statements.

Along with the accounts receivable ratios, we analyzed in Step 5, we also have

to analyze how eiciently we generate sales with our other assets - inventory,

plant and equipment, and our total asset base.

Inventory Turnover Ratio The inventory turnover ratio is one of the most important ratios a business owner can

calculate and analyze. If your business sells products as opposed to services, then

inventory is an important part of your equation for success.

Inventory Turnover = Sales/Inventory = ______ X

If your inventory turnover is rising, that means you are selling your products faster. If

it is falling, you are in danger of holding obsolete inventory. A business owner has to

Dnd the optimal inventory turnover ratio where the ratio is not too high and there are

no stockouts or too low where there is obsolete money. Both are costly to the Drm.

For this company, their inventory turnover ratio for 2010 is:

Inventory Turnover Ratio = Sales/Inventory = 2311/393 = 5.9X

This means that this company completely sells and replaces its inventory 5.9 times

every year. In 2011, the inventory turnover ratio is 6.8X. The Drm's inventory turnover

is rising. This is good in that they are selling more products. The business owner

should compare the inventory turnover with the inventory turnover ratio with other

Drms in the same industry.

Fixed Asset Turnover The Dxed asset turnover ratio analyzes how well a business uses its plant and

equipment to generate sales. A business Drm does not want to have either too little

or too much plant and equipment. For this Drm for 2010:

Fixed Asset Turnover = Sales/Fixed Assets = 2311/2731 = 0.85X

For 2011, the Dxed asset turnover is 1.00. The Dxed asset turnover ratio is dragging

down this company. They are not using their plant and equipment eiciently to

generate sales as, in both years, Dxed asset turnover is very low.

Total Asset Turnover The total asset turnover ratio sums up all the other asset management ratios. If there

are problems with any of the other total assets, it will show up here, in the total asset

turnover ratio.

Total Asset Turnover = Sales/Total Asset Turnover = Sales/Total Assets = 2311/3373 =

0.69X for 2010. For 2011, the total asset turnover is 0.66X. The total asset turnover

ratio is somewhat concerning since it was not even 1X for either year.

This means that it was not very eicient. In other words, the total asset base was not

very eicient in generating sales for this Drm in 2010 or 2011. Why?

It seems to me that most of the problem lies in the Drm's Dxed assets. They have too

much plant and equipment for their level of sales. They either need to Dnd a way to

increase their sales or sell ok some of their plant and equipment. The Dxed asset

turnover ratio is dragging down the total asset turnover ratio and the Drm's asset

management in general.

There are three debt management ratios that help a business owner evaluate

the company in light of its asset base and earning power. Those ratios are the

debt to assets ratio, the times interest earned ratio, and the Dxed charge

coverage ratios. Other debt management ratios exist, but these help give

business owners the Drst look at the debt position of the company and the prudence

of that debt position.

Debt to Assets Ratio The Drst debt ratio that is important for the business owner to understand is the debt

to assets ratio; in other words, how much of the total asset base of the Drm is

Dnanced using debt Dnancing. For example. the debt to assets ratio for 2010 is:

Total Liabilities/Total Assets = $1074/3373 = 31.8% - This means that 31.8% of the

Drm's assets are Dnanced with debt. In 2011, the debt ratio is 27.8%. In 2011, the

business is using more equity Dnancing than debt Dnancing to operate the company.

We don't know if this is good or bad since we do not know the debt to assets ratio for

Drms in this company's industry. However, we do know that the company has a

problem with their Dxed asset ratio which may be akecting the debt to assets ratio.

Times Interest Earned Ratio The times interest earned ratio tells a company how many times over a Drm can pay

the interest that it owes. Usually, the more times a Drm can pay its interest expense

the better. The times interest earned ratio for this Drm for 2010 is:

Times Interest Earned = Earnings Before Interest and Taxes/Interest = 276/141

= 1.95X

For 2011, the times interest earned ratio is 3.3X

The times interest earned ratio is very low in 2010 but better in 2011. This is because

the debt to assets ratio dropped in 2011 in 2011.

Fixed Charge Coverage The Dxed charge coverage ratio is very helpful for any company that has any Dxed

expenses they have to pay. One Dxed charge (expense) is interest payments on debt,

but that is covered by the times interest earned ratio.

Another Dxed charge would be lease payments if the company leases any equipment,

a building, land, or anything of that nature. Larger companies have other Dxed

charges which can be taken into account.

Fixed charge coverage = Earnings Before Fixed Charges and Taxes/Fixed

Charges = _____X

In both 2010 and 2011 for the company in our example, its only Dxed charge is

interest payments. So, the Dxed charge coverage ratio and the times interest earned

ratio would be exactly the same for each year for each ratio.

The last group of Dnancial ratios that business owners usually tackle are the

proDtability ratios as they are the summary ratios of the 13 ratio group. They tell

the business Drm how they are doing on cost control, eicient use of assets,

and debt management, which are three crucial areas of the business.

Net Profit Margin The net proDt margin measures how much each dollar of sales contributes to proDt

and how much is used to pay expenses. For example, if a company has a net proDt

margin of 5%, this means that 5 cents of every sales dollar it takes in goes to proDt

and 95 cents goes to expenses. For 2010, here is XYZ, Inc's net proDt margin:

Net ProDt Margin = Net Income/Sales Revenue = 89.1/2311 = 3.9%

For 2011, the net proDt margin is 6.5%, so there was quite an increase in their net

proDt margin. You can see that their sales took quite a jump plus their cost of goods

sold fell. That is the best of both worlds when sales rise and costs fall. Bear in mind,

the company can still have problems even if this is the case.

Return on Assets The return on assets ratio also called return on investment, relates to the Drm's asset

base and what kind of return they are getting on their investment in their assets.

Look at the total asset turnover ratio and the return on asset ratio together. If total

asset turnover is low, the return on assets is going to be low because the company is

not eiciently using its assets.

Another way to look at return on assets is in the context of the Dupont method of

Dnancial analysis. This method of analysis shows you how to look at return on assets

in the context of both the net proDt margin and the total asset turnover ratio.

To calculate the Return on Assets ratio for XYZ, Inc. for 2010, here's the

formula:

Return on Assets = Net Income/Total Assets = 2.6%

For 2011, the ROA is 5.2%. The increased return on assets in 2011 rerects the

increased sales, reduced costs, and much higher net income for that year.

Return on Equity The return on equity ratio is the one of most interest to the shareholders or investors

in the Drm. This ratio tells the business owner and the investors how much income

per dollar of their investment the business is earning. This ratio can also be analyzed

by using the Dupont method of Dnancial ratio analysis. The company's return on

equity for 2010 was:

Return on Equity = Net Income/Shareholder's Equity = 3.9%

For 2011, the return on equity was 7.2%. One reason for the increased return on equity

was the increase in net income. When analyzing the return on equity ratio, the

business owner also has to take into consideration how much of the Drm is Dnanced

using debt and how much of the Drm is Dnanced using equity.

Now we have a summary of all 13 Dnancial ratios for XYZ Corporation. The Drst

thing that jumps out is the low liquidity of the company. We can look at the

current and quick ratios for 2010 and 2011 and see that the liquidity is slightly

increasing between 2010 and 2011, but it is still very low.

By looking at the quick ratio for both years, we can see that this company has to sell

inventory in order to pay ok short-term debt. The company does have short-term

debt - accounts payable and notes payable, and we don't know when the notes

payable will come due.

Let's move on to the asset management ratios. We can see that the Drm's credit and

collections policies might be a little restrictive by looking at the high receivable

turnover and low average collection period. Customers must pay this company

rapidly - perhaps too rapidly. There is nothing particularly remarkable about the

inventory turnover ratio, but the Dxed asset turnover ratio is remarkable.

The Dxed asset turnover ratio measures the company's ability to generate sales from

its Dxed assets or plant and equipment. This ratio is very low for both 2010 and 2011.

This means that XYZ has a lot of plant and equipment that is unproductive.

It is not being used eiciently to generate sales for the company. In addition, the

company has to service the plant and equipment, pay for breakdowns, and perhaps

pay interest on loans to buy it through long-term debt.

It seems that a very low Dxed asset turnover ratio might be a major source of

problems for XYZ. The company should sell some of this unproductive plant and

equipment, keeping only what is absolutely necessary to produce their product.

The low Dxed asset turnover ratio is dragging down total asset turnover. If you follow

this analysis on through, you will see that it is also substantially lowering this Drm's

return on assets proDtability ratio.

With this Drm, it is hard to analyze the company's debt management ratios without

industry data. We don't know if XYZ is a manufacturing Drm or a dikerent type of Drm.

As a result, analyzing the debt to asset ratio is diicult. What we can see, however, is

that the company is Dnanced more with shareholder funds (equity) than it is with

debt as the debt to asset ratio for both years is under 50% and dropping.

This fact means that the return on equity proDtability ratio will be lower than if the

Drm was Dnanced more with debt than with equity. On the other hand, the risk of

bankruptcy will also be lower.

Unfortunately, you can see from the times interest earned ratio that the company

does not have enough liquidity to be comfortable servicing its debt. The company's

costs are high and liquidity is low. Fortunately, the company's net proDt margin is

increasing because their sales are increasing and their costs are decreasing.

Hopefully, this is a trend that will continue. Return on Assets is impacted negatively

due to the low Dxed asset turnover ratio and, to some extent, by the receivables

ratios. Return on Equity is increasing from 2010 from 2011, which will make investors

happy.

As you can see, it is possible to do a cursory Dnancial ratio analysis of a business Drm

with only 13 Dnancial ratios, even though ratio analysis has inherent limitations.

B U S I N E S S F I N A N C E B U S I N E S S F I N A N C E S M A L L B U S I N E S SS M A L L B U S I N E S S

B YB Y Updated November 20, 2019R O S E M A R Y C A R L S O NR O S E M A R Y C A R L S O N

The Balance Sheet for Financial Ratio Analysis0101

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$69.97 $73.97

$102.97 $150

$150 $102.97

$70 $150

The Income Statement for Financial Ratio Analysis0202

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$150 $102.97

Analyzing The Liquidity Ratios0303

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Analyzing the Asset Management Ratios Accounts Receivable

0404

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Inventory, Fixed Assets, Total Assets0505

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Analyzing the Debt Management Ratios0606

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Analyzing the Profitability Ratios0707

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Financial Ratio Analysis of XYZ Corporation0808

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