Overview

Ratio analysis is an excellent tool for providing critical insight about a company's financial condition and future prospects. Creditors and lenders rely on ratio analysis because ratios provide increased information about a company's ability to meet its loan interest and principal payments (e.g., coverage ratio). Ratios specifically can provide the analyst with information about the following:

1. Consequences of financing decisions.
2. The effects of managerial decisions with regard to earnings (e.g., distributing versus retaining profits).
3. Trends in the income statement and balance sheet accounts over several accounting periods.

Ratio analysis is the art of analyzing the relationships between two or more amounts in a company's financial statements. The actual ratio results are much more meaningful when compared with a company's historical results or industry averages. Ratio results for a given year viewed in isolation can contribute to erroneous conclusions about a company's financial position. As a result, the analyst should consider industry performance.

Purpose of Ratio Analysis

Although financial statements provide much useful information, the large numbers and varying sizes of companies make it difficult to compare performance from company to company and from year to year within one company. Ratio analysis is a useful technique for evaluating the various financial characteristics of a company. Applying ratio analysis to financial statements enables the analyst to make judgments about the success, failure, and progress of a company over time and to evaluate how a company is performing compared with similar companies in the same industry.

Most industry and trade associations publish industry average ratios based on data compiled by the association from member reports. Considerable data regarding industry averages is available from Dun & Bradstreet, Robert Morris Associates, and various Internet sites. Several years' ratios should be compared to determine if any unfavorable trends are developing.

Ratio analysis is a key part of an integrated financial statement analysis plan. This plan should include the following five key steps:

1. Determine the objectives of the financial statement analysis.
2. Review the current and predicted economic conditions in the industry in which the company operates.
3. Consult the annual report and other regulatory filings to glean information about management and the
4. company's accounting methods.
5. Analyze the financial statements using the tools described in this series of articles.
6. Draw relevant conclusions based on the initial objectives.

In contrast to the snapshot concept of the balance sheet, which captures a company's position as of a given date, the income statement indicates the flow of sales, expenses, and earnings during a period of time. The income statement provides an indication of how well the company operated during the accounting period. Consequently, income statement ratios primarily are profitability ratios.

However, income statement ratios also rely on data found in a company's balance sheets. For purposes of the ratios illustrated in this article, the Office Depot, Inc. and Subsidiaries Consolidated Balance Sheets are shown in Exhibit 4.

Analysts employ financial ratios because numbers in isolation have little value. Financial ratios are particularly useful for analyzing a company's performance relative to its industry. The influence of industrywide conditions of the companies within the industry is always strong. The following ratios can assist the analyst in obtaining a closer look at the company's financial situation.

Exhibit 4: Office Depot, Inc. and Subsidiaries Consolidated Balance Sheets

Financial Statement Ratios

Economic developments and legislation affect industries in which individual companies operate. In order to maximize the benefit of financial statement analysis, it is key to evaluate the environment in which a company operates.

Financial statement ratios can indicate a company's potential strengths and weaknesses, but they are not necessarily predictors of the future. Ratios should be viewed with common sense and integrated with the results found in other financial analysis tools. The income statement ratios described here are some of the more common financial ratios. Calculations reflect 1998 Office Depot data unless indicated otherwise.

There are three broad classes of ratios:

• Profitability ratios
• Liquidity ratios
• Solvency ratios

Profitability Ratios

Profitability ratios measure a company's ability to generate income and frequently are used as the ultimate test of managerial effectiveness. Long-term investors buy shares of a company's stock with the expectation that the company will produce a growing stream of cash or earnings. These ratios measure a company's historical performance in generating returns on assets or equity and are useful in estimating future earnings.

Profits must be analyzed in context with the drivers that boost profitability. For example, the analyst may want to investigate profitability ratio results further if executive bonuses are based upon profitability.  The analyst will likely want to evaluate trends to verify that high net earnings in a given year are consistent with prior years.

Return On [Total] Assets Ratio. This ratio measures how efficiently a company uses its assets in the production of net income. In addition, it reports the total return accruing to all providers of capital (debt and equity), independent of the source of capital. The computation is as follows:

 

Return on assets	=	Net income before income taxes
		Average total assets

The calculation for average total assets can be approximated by taking the total assets from the beginning of the period, adding the total assets from the ending of the period, and dividing the sum by two. The return on total assets for Office Depot, as of December 26, 1998, totals .1018 or 10.18%. The numerator is taken from Exhibit 1 (see Part One) and the denominator, total assets, appears in Exhibit 4. This return should be compared with the returns of other companies in the same industry.

 

Return on assets	=	$388,727	=	10.18%
		($4,113,041 + $3,520,819)/2

Profit Margin Before Income Taxes Ratio. This ratio measures the rate of profit on each sales dollar received. It indicates how well management has translated revenues into earnings available for shareholders. The numerator in this ratio is the same numerator shown in the return on assets ratio. The denominator equals total sales for the period.

 

Profit margin before income taxes	=	Net income before income taxes
		Sales

 The result of this ratio for Office Depot for 1998 is .0432.

 

Profit margin before income taxes	=	$388,727	=	4.32%
		$8,997,738

Total Asset Turnover Ratio. The purpose of the total asset turnover ratio is to show how effectively the firm uses its total assets to generate sales. This ratio is similar to the return on total assets, which uses net income before income taxes in the numerator.

If the turnover ratio is high, the implication is that the company is using its assets effectively to generate sales. If the turnover ratio is low, the company has to use its assets more efficiently or dispose of them.

This ratio must be compared to other companies in the same industry because it varies substantially among industries. For example, total asset turnover ratios range from about 1.00 time for large capital-intensive industries to over 10.00 times for some retailing operations.

Total asset turnover	=	Sales
		Average total assets

Total asset turnover for Office Depot is calculated at 2.36 times.

Total asset turnover	=	$8,997,738	=	2.36 times
		($4,113,041 + $3,520,819)/2

 Profit Margin After Income Taxes Ratio. This ratio is similar to profit margin before income taxes. The subtle difference is that this ratio includes net income after income taxes, which may be important depending upon the type of analysis being performed. The profit margin percentage measures a company's ability to sell its products for higher prices compared with its competitors and to control the level of expenses relative to sales revenues.

 

Profit margin after income taxes	=	Net income after income taxes
		Sales

The following calculation represents the profit margin after income taxes for Office Depot for 1998. The result is .0259.

 

Profit margin after income taxes	=	$233,196	=	2.59%
		$8,997,738

 Return on Equity Ratio. The return on equity ratio compares a company's after-tax net income to the amount of investment by the common stockholders. Common stockholders' equity is total stockholders' equity minus the amount allocated to preferred stock.

Based on the analyst's preference, equity reported at the end of the period can be substituted for average equity. Return on equity reflects the return on a given level of equity. This ratio is particularly important to the owners (stockholders) of the company since it measures the return on their investment. The calculation is as follows:

 

Return on equity	=	Net income after income taxes – Preferred dividends
		Average common stockholders' equity

 The return on equity ratio for Office Depot is .1245.

 

Return on equity	=	$233,196 – $0	=	12.45%
		($2,028,879 + $1,717,638)/2

When the rate of return on total assets is lower than the rate of return on equity, the company is said to be trading on the equity at a gain. The expression "trading on the equity" describes the practice of borrowing funds at fixed interest rates in hopes of obtaining a higher rate of return on the money used. Trading on the equity increases a company's financial risk, but it also increases earnings whenever the rate of return on assets exceeds the cost of debt capital.

Liquidity Ratios

Profitability ratios provide information about a company's earnings picture, but the liquidity ratios describe how easily those earnings can be converted into cash. The ability of a company to generate cash to pay its short-term obligations parallels its ability to stay in business. The more popular liquidity ratios related to the income statement are presented as follows.

Net Sales to Working Capital Ratio. The difference between current assets and current liabilities is referred to as "working capital." Corporate analysts may use working capital to estimate a company's liquidity. The net sales to working capital ratio indicates the level of sales generated for each $1.00 of working capital.

 

Net sales to working capital	=	Sales
		Average working capital

 Office Depot reports a relationship of $7.68 in net sales for each dollar of working capital.

 

Net sales to working capital	=	$8,997,738	=	7.68 to 1
		($2,780,435 – $1,531,001 + $2,381,079 – $1,287,616)/2

Receivables Turnover Ratio. This ratio measures how quickly a company converts its accounts receivable to cash, completing the sales cycle. Generally credit sales are preferred for the numerator, but this amount is rarely reported separately in audited financial statements; so the amount reported for total sales is used in this ratio.

Cash is the lifeblood of an organization. High revenues may be reported by an organization, but those accruals must be converted into cash quickly for an organization to thrive. A decreasing figure over time is a red flag. To determine whether the account collection numbers are good or bad, they should be related to a company's credit policy and to other firms in the same industry.

 

Receivables turnover	=	Sales
		Average accounts receivable

 The receivables turnover for Office Depot is 13.0949. To calculate the average collection period of 27.87 days, the formula is 365 days divided by 13.0949.

 

Receivables turnover	=	$8,997,738	=	13.0949
		($721,446 + $652,786)/2

 Inventory Turnover Ratio. This measure of liquidity indicates the number of times merchandise inventory is purchased and sold during an accounting period. A higher ratio means that inventory is not languishing in warehouses or on the shelves.

This ratio is industry specific. For example, supermarkets will have a higher turnover than jewelry stores. The calculation of the inventory turnover ratio is as follows:

Inventory turnover		=	Cost of sales
			Average inventory

 Inventory turnover for Office Depot is 4.88 times.

 

Inventory turnover	=	$6,484,464	=	4.88 times
		($1,258,355 + $1,397,266)/2

Solvency Ratios

This section covers one income statement solvency ratio. Solvency ratios describe a company's ability to meet the principal and interest payments on its long-term debt. The following income statement solvency ratio focuses on the company's ability to meet its interest payments.

Coverage Ratio. This ratio is often referred to as the "times interest earned" ratio. The calculation suggests a company's ability to meet its regularly scheduled interest payments. Creditors are fond of this ratio, as it compares the earnings (as adjusted) available to pay interest. The numerator is adapted to exclude interest and income tax expenses to arrive at the amount of earnings available to pay interest.

 

Coverage ratio	=	Earnings before interest expense and income taxes
		Interest expense

 The coverage ratio for Office Depot is 18.39 times.

 

Coverage ratio	=	$388,727 + $22,356		=	18.39 times
		$22,356

Earnings per Share

Many investors and analysts rely on the earnings per share (EPS) statistic more than any other indicator. In Exhibit 1, EPS for Office Depot is shown on a basic and diluted basis, as required by GAAP. The EPS ratio represents the net earnings attributable to each share of common stock outstanding. The numerator in this ratio reports the net income available to common stockholders, while the denominator reflects the weighted-average number of shares of common stock outstanding.

The fully diluted version includes the potential impact of convertible securities in the formula (e.g., convertible bonds, convertible preferred stocks, stock options, and warrants). The presence of these securities means that the number of common shares outstanding may increase in the future, resulting in a dilution (reduction) of EPS. The basic EPS equation is presented as follows:

 

Earnings per Share	=	Net income – Preferred dividend requirement
		Weighted-average number of shares of common stock outstanding

 To illustrate the concept between basic and diluted EPS, assume a company has one million shares of common stock outstanding and 100,000 shares of convertible preferred stock, each share of which can be converted into one share of common stock. If net income is $500,000 and dividends of $20,000 are payable to preferred shareholders, basic EPS of $.48 may be calculated as follows:

 

Basic Earnings per Share	=	$500,000 – $20,000	=	$.48
		1,000,000 shares

If the convertible preferred stock is converted into common stock, EPS will be diluted. Assuming conversion at the beginning of the year, the potential earnings dilution is $.03 per share, as the diluted EPS result is $.45. Since the preferred stock was converted at the beginning of the year, the numerator is adjusted to exclude the $20,000 in preferred dividends.

Diluted Earnings per Share	=	$500,000 - $0	=	$.45
		1,100,000 shares

Analysts should not rely solely on EPS. Other indicators in the income statement, such as trends in gross margin, may be more significant than EPS. Additionally, EPS may reveal little about the financial condition and cash flows of a company. EPS is one of the many ratios available that can measure management's performance over time.