Use of Financial Ratios

A Financial Ratio is an Types of

index that relates two Comparisons
accounting numbers
and is obtained by Internal
dividing one number by Comparisons
the other. External
Comparisons
 External Comparisons and
Sources of Industry Ratios
This involves comparing Examples:
the ratios of one firm with
Risk Management
those of similar firms or
Association
with industry averages.
Dun & Bradstreet
Similarity is important as Almanac of Business
one should compare and Industrial
“apples to apples.” Financial Ratios
 Liquidity Ratios
Balance Sheet Ratios Current

Current Assets
Liquidity Ratios Current Liabilities
Shows a firm’s ability to
For Basket Wonders
cover its current December 31, 2007
liabilities with its
current assets. $1,195 = 2.39
$500
 Liquidity Ratio Comparisons

Current Ratio
Year BW Industry
2007 2.39 2.15
2006 2.26 2.09
2005 1.91 2.01

Ratio is stronger than the industry average.

 Liquidity Ratios
Balance Sheet Ratios Acid-Test (Quick)

Current Assets - Inv

Liquidity Ratios Current Liabilities
Shows a firm’s ability to For Basket Wonders
meet current liabilities December 31, 2007
with its most liquid
assets. $1,195 – $696 = 1.00
$500
 Liquidity Ratio
Comparisons
Acid-Test Ratio
Year BW Industry
2007 1.00 1.25
2006 1.04 1.23
2005 1.11 1.25

Ratio is weaker than the industry average.

 Summary of the Liquidity Ratio
Comparisons
Ratio BW Industry
Current 2.39 2.15
Acid-Test 1.00 1.25
• Strong current ratio and weak acid-test ratio
indicates a potential problem in the inventories
account.
• Note that this industry has a relatively high
level of inventories.
 Current Ratio – Trend Analysis
Comparison
Trend Analysis of Current Ratio
2.5
2.3
Ratio Value

2.1
BW
1.9 Industry
1.7
1.5
2005 2006 2007
Analysis Year
 Acid-Test Ratio – Trend Analysis
Comparison
Trend Analysis of Acid-Test Ratio

1.5

1.3
Ratio Value

1.0 BW
Industry
0.8

0.5
2005 2006 2007
Analysis Year
 Summary of the Liquidity Trend
Analyses
• The current ratio for BW has been rising at the
same time the acid-test ratio has been
declining.
• The current ratio for the industry has been
rising slowly at the same time the acid-test
ratio has been relatively stable.
• This indicates that inventories are a significant
problem for BW.
 Financial Leverage Ratios
Balance Sheet Ratios Debt-to-Equity

Total Debt
Financial Leverage Shareholders’ Equity
Ratios
For Basket Wonders
December 31, 2007
Shows the extent to
which the firm is financed $1,030 = 0.90
by debt. $1,139
 Financial Leverage
Ratio Comparisons
Debt-to-Equity Ratio
Year BW Industry
2007 0.90 0.90
2006 0.88 0.90
2005 0.81 0.89
BW has average debt utilization
relative to the industry average.
 Financial Leverage Ratios
Balance Sheet Ratios Debt-to-Total-Assets

Total Debt
Financial Leverage Total Assets
Ratios
For Basket Wonders
Shows the percentage of December 31, 2007
the firm’s assets that are
supported by debt $1,030 = 0.47
financing. $2,169
 Financial Leverage
Ratio Comparisons
Debt-to-Total-Asset Ratio
Year BW Industry
2007 0.47 0.47
2006 0.47 0.47
2005 0.45 0.47
BW has average debt utilization
relative to the industry average.
 Financial Leverage Ratios
Balance Sheet Ratios Total Capitalization
(i.e., LT-Debt + Equity)

Financial Leverage Total Debt

Ratios Total Capitalization

Shows the relative For Basket Wonders

importance of long-term debt December 31, 2007
to the long-term financing of $1,030
the firm. = 0.62
$1,669
 Financial Leverage
Ratio Comparisons
Total Capitalization Ratio
Year BW Industry
2007 0.62 0.60
2006 0.62 0.61
2005 0.67 0.62
BW has average long-term debt utilization
relative to the industry average.
 Coverage Ratios
Income Statement Interest Coverage
Ratios
EBIT
Interest Charges
Coverage Ratios
For Basket Wonders
Indicates a firm’s ability December 31, 2007
to cover interest
charges. $210 = 3.56
$59
 Coverage
Ratio Comparisons
Interest Coverage Ratio
Year BW Industry
2007 3.56 5.19
2006 4.35 5.02
2005 10.30 4.66
BW has below average interest coverage
relative to the industry average.
Coverage Ratio – Trend
Analysis Comparison
Trend Analysis of Interest Coverage Ratio
11.0

9.0
Ratio Value

7.0 BW
Industry
5.0

3.0
2005 2006 2007
Analysis Year
 Summary of the Coverage
Trend Analysis
• The interest coverage ratio for BW has been
falling since 2005. It has been below industry
averages for the past two years.

• This indicates that low earnings (EBIT) may be

a potential problem for BW.
• Note, we know that debt levels are in line with
the industry averages.
 Activity Ratios
Income Statement/ Receivable Turnover
(Assume all sales are credit sales.)
Balance Sheet
Ratios Annual Net Credit Sales
Receivables
Activity Ratios
For Basket Wonders
Indicates quality of December 31, 2007
receivables and how
successful the firm is in its $2,211 = 5.61
collections. $394
 Activity Ratios
Income Statement/ Avg Collection Period
Balance Sheet
Days in the Year
Ratios
Receivable Turnover

Activity Ratios For Basket Wonders December

31, 2007
Average number of days
that receivables are
outstanding. 365 = 65 days
(or RT in days) 5.61
 Activity
Ratio Comparisons
Average Collection Period
Year BW Industry
2007 65.0 65.7
2006 71.1 66.3
2005 83.6 69.2
BW has improved the average collection
period to that of the industry average.
 Activity Ratios
Income Statement/ Payable Turnover (PT)
(Assume annual credit
Balance Sheet purchases = $1,551.)
Ratios
Annual Credit Purchases
Accounts Payable
Activity Ratios

Indicates the promptness of For Basket Wonders

payment to suppliers by the December 31, 2007
firm. $1551
= 16.5
$94
 Activity Ratios
Income Statement/ PT in Days
Balance Sheet
Ratios Days in the Year
Payable Turnover
Activity Ratios
For Basket Wonders December
31, 2007
Average number of days
that payables are 365
outstanding. = 22.1 days
16.5
 Activity
Ratio Comparisons
Payable Turnover in Days
Year BW Industry
2007 22.1 46.7
2006 25.4 51.1
2005 43.5 48.5
BW has improved the PT in Days.
Is this good?
 Activity Ratios
Income Statement/ Inventory Turnover
Balance Sheet
Ratios Cost of Goods Sold
Inventory
Activity Ratios
For Basket Wonders December
Indicates the effectiveness 31, 2007
of the inventory
management practices of $1,599 = 2.30
the firm. $696
 Activity
Ratio Comparisons
Inventory Turnover Ratio
Year BW Industry
2007 2.30 3.45
2006 2.44 3.76
2005 2.64 3.69

BW has a very poor inventory turnover ratio.

 Inventory Turnover Ratio –Trend
Analysis Comparison
Trend Analysis of Inventory Turnover Ratio
4.0

3.5
Ratio Value

3.0 BW
Industry
2.5

2.0
2005 2006 2007
Analysis Year
 Activity Ratios
Income Statement/ Total Asset Turnover
Balance Sheet
Ratios Net Sales
Total Assets
Activity Ratios
For Basket Wonders December
Indicates the overall 31, 2007
effectiveness of the firm in
utilizing its assets to $2,211 = 1.02
generate sales. $2,169
 Activity
Ratio Comparisons
Total Asset Turnover Ratio
Year BW Industry
2007 1.02 1.17
2006 1.03 1.14
2005 1.01 1.13
BW has a weak total asset turnover ratio.
Why is this ratio considered weak?
 Profitability Ratios
Income Statement/ Gross Profit Margin
Balance Sheet
Ratios Gross Profit
Net Sales
Profitability Ratios
For Basket Wonders December
31, 2007
Indicates the efficiency of
operations and firm pricing $612 = 0.277
policies. $2,211
 Profitability
Ratio Comparisons
Gross Profit Margin
Year BW Industry
2007 27.7% 31.1%
2006 28.7 30.8
2005 31.3 27.6

BW has a weak Gross Profit Margin.

Gross Profit Margin –
Trend Analysis Comparison
Trend Analysis of Gross Profit Margin
35.0

32.5
Ratio Value (%)

30.0 BW
Industry
27.5

25.0
2005 2006 2007
Analysis Year
 Profitability Ratios
Income Statement/ Net Profit Margin
Balance Sheet
Ratios Net Profit after Taxes
Net Sales
Profitability Ratios
For Basket Wonders December
Indicates the firm’s 31, 2007
profitability after taking
$91 = 0.041
account of all expenses and
$2,211
income taxes.
 Profitability Ratio
Comparisons
Net Profit Margin
Year BW Industry
2007 4.1% 8.2%
2006 4.9 8.1
2005 9.0 7.6

BW has a poor Net Profit Margin.

Net Profit Margin –
Trend Analysis Comparison
Trend Analysis of Net Profit Margin
10
9
Ratio Value (%)

8
7 BW
Industry
6
5
4
2005 2006 2007
Analysis Year
 Profitability Ratios
Income Statement/ Return on Investment
Balance Sheet
Ratios Net Profit after Taxes
Total Assets
Profitability Ratios
For Basket Wonders December
Indicates the profitability on 31, 2007
the assets of the firm (after
all expenses and taxes). $91 = 0.042
$2,160
 Profitability
Ratio Comparisons
Return on Investment
Year BW Industry
2007 4.2% 9.6%
2006 5.0 9.1
2005 9.1 10.8

BW has a poor Return on Investment.

Return on Investment –
Trend Analysis Comparison
Trend Analysis of Return on Investment
12

10
Ratio Value (%)

8 BW
Industry
6

4
2005 2006 2007
Analysis Year
 Profitability Ratios
Income Statement/ Return on Equity
Balance Sheet
Ratios Net Profit after Taxes
Shareholders’ Equity
Profitability Ratios
For Basket Wonders December
Indicates the profitability to 31, 2007
the shareholders of the firm
(after all expenses and $91 = 0.08
taxes). $1,139
 Profitability
Ratio Comparisons
Return on Equity
Year BW Industry
2007 8.0% 18.0%
2006 9.4 17.2
2005 16.6 20.4

BW has a poor Return on Equity.

Return on Equity –
Trend Analysis Comparison
Trend Analysis of Return on Equity
21.0
Ratio Value (%)

17.5

14.0 BW
Industry
10.5

7.0
2005 2006 2007
Analysis Year
• Trend analysis provides signals as to whether the company's
financial health is likely to improve or deteriorate.

• Leverage Ratios: to measure the extent to which the company's

assets are financed with debt;

• Liquidity Ratios: to measure the company's ability to pay its bills;

• Profitability Ratios: to measure the company's ability to

generate earnings;

• Efficiency Ratios: to measure the company's ability to utilize its

assets;

• Market Value Ratios: to measure the market perception about

the company's future prospects.