Financial Ratio Analysis, a Tool That Shows

¶ … financial ratio analysis, a tool that shows how figures between the balance sheet and the income sheet are related. Ratios are used to appraise a company's past financial performance and its potential for the future. A company's financial statements are of interest to creditors, investors, financial analysts and internal accountants. Using ratios helps them to analyze the overall financial health of a business. By computing financial ratios, one is better able to evaluate a company's financial status and operating performance for a given time period.

Here are some of the advantages of ratio analysis:

It simplifies the comprehension of financial statements.

It facilitates comparisons between firms.

It highlights the factors associated with strong firms and weak firms.

It provides a helpful tool in investment decisions.

Here are some limitations of ratios analysis:

It is susceptible to personal bias by the people interpreting them.

It analyzes historical data, making its predictive value limited.

Financial ratios are classified according to the information they provide. The following list includes some typical categories:

Liquidity measurement

Debt ratios

Profitability indicators

Investment valuation ratios

Ratios are used for a number of measuring techniques to analyze the financial health of a business, including industry comparison and trend analysis. For industry comparison purposes, a company's ratios are compared with those of similar companies or with industry norms to gauge how well the company is doing relative to its competitors. With trend analysis, a company's current year ratios are compared with its previous ratios to determine if the company's financial condition is improving or deteriorating. When analysis uncovers a problem, an attempt should be made to discover the reasons for the change.

Horizontal analysis is used to appraise the trend in accounts over the years, and may also be carried out by computing trend percentages that state several years' financial data in terms of a base year. Companies typically report comparative financial data for five years in their annual reports. Comparative balance sheets make it relatively easy to spot trends that require additional investigation.

Vertical analysis uses the biggest item on a financial statement as a base value, and then all other items on the financial statement are compared to it. Each item is stated as a percentage of some total of which that item is a part. The resulting figures are then presented in common size statements, which are especially useful for comparing data from different companies. Vertical analysis is a tool for understanding the internal structure of a business, showing the relationship between each income statement account and revenue. Similar to horizontal analysis, vertical analysis can indicate problem areas that need closer attention.

Liquidity Ratios

Liquidity measures a company's ability to meet its short-term debt. Creditors in particular are concerned with liquidity; a company with a poor liquidity position may represent a poor credit risk. They may be unable to make timely interest and principal payments. Liquidity ratios are static as of year-end. For this reason they should be examined in conjunction with future cash flows.

One important liquidity ratio is the current ratio, which tests liquidity by measuring a firm's ability to pay liabilities that will be due in the near future. The current ratio, also known as the working capital ratio, is calculated from the balance sheet. It equals current assets divided by current liabilities:

Costco's current ratio for fiscal years 2010 is (dollars in millions):

$11,708 $10,063 = 1.16

The current ratio is used to appraise the ability of the company to satisfy its current debt out of current assets. Seasonal fluctuations will impact this ratio. Short-term creditors prefer a high current ratio because it reduces their risk. Shareholders typically prefer a lower current ratio so that more of the company's assets are working to grow the business. One limitation of the current ratio is that inventory may include many items that are difficult to liquidate quickly and that have uncertain liquidation values. Another drawback is that it will be higher when inventory is carried on a LIFO basis. Also this ratio is susceptible to manipulation by overvaluing the current assets. Other liquidity measures include working capital, the quick ratio, and cash flow ratios.

Debt Ratios

Debt ratios measure solvency, the company's ability to satisfy its long-term debt as it becomes due. An evaluation of solvency focuses on the company's long-term financial and operating structure. Excessive long-term debt is associated with greater risk. Debt ratios are calculated from the balance sheet.

The debt-to-equity ratio is a solvency measurement calculated from balance sheet figures. Its purpose is to provide an idea of the cushion available to outsiders in the event of liquidation. A high degree of debt in the capital structure may make it difficult for the company to satisfy interest charges and principal payments at maturity. Also, a high debt position brings the risk of running out of cash under adverse conditions. Excessive debt can also cause less financial flexibility because the company will have more difficulty obtaining funds during a tight money market. A desirable debt to equity ratio depends on many factors, including the rates of other firms in the industry, access to debt financing, and earnings stability.

Debt-to-equity ratio = Total liabilities Total equity

Costco's debt-to-equity ratio for 2010 (dollars shown in millions) is:

$12, 885 $10,930 = 1.18

Profitability Ratios

Profitability ratios appraise a company's financial health by checking its ability to generate a satisfactory profit and return on investment. Profitability ratios are calculated from the income statement. The net profit margin is a key ratio of operating performance. Net profit margin equals net income divided by net sales, derived from the income statement. It reveals the company's profitability obtained from revenue and is an essential indicator of operating activity. This ratio gives an indication of the firm's capacity to face adverse economic conditions such as low demand or price competition. It also gives an indication of the company's pricing, cost structure, and production efficiency. When this ratio remains the same from year to year, it indicates that the earning power of the business has remained static.

Net Profit Margin = Net income Net sales

Costco's net profit margin from 2010 (dollars shown in millions) is:

$1,303 $76, 255 = 0.017

Investment Valuation Ratios

Market value ratios compare the company's market price of stock per share to earnings, or book value, per share. These ratios are calculated from the income statement. Book value per share is determined by dividing net assets available to common stockholders by outstanding shares. Comparing book value per share with market price per share provides an indication how investors feel about the company's financial suitability.

Book value per share = Total stockholders' equity -- Preferred stock Outstanding shares

Costco's book value per share is: $10, 930,000,000 435,974,000 = $25.07

Understanding the Limitations of Ratio Analysis

One must be aware of the limits inherent in ratio analysis. One such limitation is that a reference point is necessary. For ratios to be meaningful, they need to be compared to either historical values of the same firm, the firm's forecasts, or ratios of similar firms. It may be difficult to identify the industry group to which a company belongs, making industry comparisons a problem.