What are Financial Ratios

Financial ratios are used by analysts, investors, lenders and managers to judge a company's financial performance and condition. Still, Comparing Companies Financial Ratios and financial analysis is more of an art than a science. The set of ratios that proves most useful in any particular application depends on the company being analyzed, the purpose of the analysis and the analyst's judgments. Lenders typically are most concerned with the company's liquidity, coverage and leverage ratios. They may believe that the greater the liquidity and the lower the leverage, the greater the likelihood that interest and principal payments will be made on time. Managers are also likely to be concerned with the profitability of the enterprise. They must be concerned with turnover ratios and profitability measures too, because these ratios show how effectively the company is using its assets. Shareholders are most concerned with investment returns. As a result, common stockholders tend to emphasize profitability ratios, return on common stockholders equity and market value ratios.

Financial information can be obtained from the company itself as well as from financial service companies, government agencies, trade associations and many other sources. Information is increasingly available in electronic form instead of in a printed medium. Table No. 1 provides examples of several important providers of financial information.

Analysts, investors and managers face a number of challenging and interesting situations whenever they undertake financial statement analysis. Several important tools you can use and several problems you may encounter are described and discussed below.

Choosing Financial Ratios

Earlier in the posts, we presented a set of basic financial ratios. As we noted then, however, many other ratios are used to meet the needs of specialized analysts representing particular clienteles or focusing on specific industries. Fortunately, each specialty tends to use a limited set of ratios. Unfortunately, the names of financial ratios are not standardized. A particular ratio might have several names (as does the acid test ratio and the quick ratio). Even more disturbing is the fact that many ratios called by the same name have different definitions.

For example, when calculating an inventory turnover ratio, some analysts use the end-of-year inventory in the denominator, as we did. But others use an average of the inventory over the year. Also, some analysts use sales in the numerator of the inventory turnover ratio instead of cost of goods sold.

Similarly, the P/E may be calculated in different ways. It's most often calculated (and reported in the financial press) by dividing the current market price by the last year's EPS (that is, total EPS for the last four quarters). Alternative P/Es are constructed by dividing the current market price by the forecasted earnings per share for the next year.

As you can see, unlike a rose, a ratio by any other name (or even by the same name) may not smell as sweet. Therefore, whenever ratios are supplied by others, you must know their exact definition if they are to be of any use.

Table 1

    Major Sources of Financial Information

Discriminant Analysis and Credit Scoring

One tool used to assess the financial health of a company is called discriminant analysis. This statistical procedure combines several variables (such as a company's financial ratios)into a single score in an attempt to classify the company into one of various groupings. Such analysis can be used to predict significant events, such as bankruptcy or a bond rating change. 

In the case of bond ratings, the rating predicted by discriminant analysis is compared with the actual rating. For example, a discriminant analysis might reveal that a company whose bonds are currently rated BBB has financial characteristics more similar to those companies whose bonds are rated A. This would suggest that the bonds have lower default risk than the BBB rating would indicate. The analysis would predict an improvement in the rating. 

Discriminant analysis models are also used for evaluating commercial loans, consumer loans and credit card applications. Such models are often called credit scoring models. As the likelihood of default.

Cross-Sectional Analysis

Cross-Sectional analysis evaluates a company's financial ratios against industry averages or averages for a selected set of comparable companies. As you would expect from the Behavioral Principle, more meaningful comparisons are often possible using specific companies. Table 2 shows selected financial ratios from the Annual Statement Survey published by

Table 2

    Selected Ratios for SIC# 5942, Retailer-Books

Robert Morris Associates. The information in the table illustrates the distribution of a financial ratio within an industry.

Suppose you're interested in book retailers. Table 2 divides the firms into three size classes and shows the 25th percentile, 50th percentile and 75th percentile of five ratios for this industry. The industry averages are broken down further by company size, as measured by most recent total annual sales. For example, for the smallest companies, the 25th percentile current ratio (25% are below this amount) is 0.9. The 50th percentile (median) current ratio is 1.5 and the 75th percentile current ratio is 2.5. Using this kind of information, a company can compare itself to other companies of similar size in the same industry.

Beyond simple industry/size comparisons, many companies engage in benchmarking. Benchmarking is a comparison to a more specific set of benchmark companies. For example, suppose the Olin Corporation wants to compare itself to Dow Chemical, DuPont, Monsanto and Union Carbide. Table 3 provides the ratios for all five companies. As you can see, Olin is most like Union Carbide, Olin's inventory turnover, receivables turnover and total asset turnover are higher than those of Dow, DuPont, and Monsanto, but similar to those of Union Carbide. Day's sales outstanding and the days sales in inventory are below the benchmark companies, except for Union Carbide.

Time-Series Analysis

Trends in financial ratios and of common-size statement items are studied very carefully by managers and analysts. Changes in a company's liquidity, financial leverage, asset turnover, or profitability ratios over time can be very meaningful.

Table 3

Asset Turnover Ratios for Benchmark Company Group

General economic conditions, industry conditions, specific managerial decisions, or simply good or bad luck might explain what is happening. Table 4 shows an eight-year series of profitability ratios for three companies. Notice how the net profit margin, return on assets and return on equity declined significantly from 1988 until 1993 for Chrysler. In 1994 and 1995, Chrysler recovered dramatically. Compare Chrysler's ratios to those of McDonald's and PepsiCo, the soft drink and food conglomerate. The profitability ratios for McDonald's and PepsiCo were fairly stable. The patterns in these ratios imply that Chrysler is a riskier company than McDonald's and PepsiCo.

Financial Planning Models and Strategic Planning Models

The structure of financial statements underlies many models that companies build for internal as well as external use. For example, a company applying for a bank loan might be required to submit historical financial statements as well as projected (what are called pro forma) financial statements for the next several years. Banks use such projected statements to help judge the likelihood the company will be able to repay the loan. Other models are used internally by management to plan the company's future investments and financing.

Inflation and Book Values

Financial decisions should be based on current and expected future conditions. However, as we emphasized in the previous posts, accounting statements are historical in the United States and many other countries. In particular, we showed how several factors, such as inflation, can distort the balance sheet.

Inflation can also distort a company's reported income. When a company gets an inflated price from selling its finished goods from inventory, it appears to have had higher income. However, it must then in turn pay an inflated price for the cost of goods to replenish its inventory for the next sale. If the company uses the so called LIFO (last in, first out) convention to overcome this problem, that will distort its balance sheet by understating the inventory value. 

Fixed assets also will have to be replaced at inflated prices in the future. However, U.S. tax laws compute depreciation on a historical cost basis. This too inflates the company's income. Taxes are paid on this overstated income, which further impinges on cash flow.

In fact, inflation is the major reason for using common-size and common-base-year financial statements. Many, but not all, of the distortions caused by inflation are reduced by scaling the information by a common base.

Some countries with high inflation rates, such as Mexico, actually require that accounting statements be adjusted for inflation. With out such adjustments, meaningful interperiod 

Table 4

    Time-Series Profitability Ratios for Chrysler, McDonald's and PepsiCo (All ratios are in percent)

comparisons or comparisons among companies can be almost impossible. As Mexico becomes a larger trading partner with the United States, in part because of the North American Free Trade Agreement (NAFTA), accounting for differences in inflation will remain important to all stakeholders in Mexican companies.

International Accounting

In the previous posts, we noted how accounting standards can differ substantially across countries. This is an additional significant impediment to using and interpreting financial information. In addition, there are the problems of language translation and foreign currency conversion. There are other differences as well. Auditing standards vary. Disclosure ranges from fairly open to almost completely secret. Legal systems, business practices, educational levels and management sophistication all vary widely. In fact, even seemingly similar countries, such as the United States and Great Britain, have differences that can surprise you. Just as it takes considerable effort to learn to read and interpret U.S. financial statements, it takes additional effort to learn how to understand those from other countries.

Judgment, Experience and Hard Work

There is no unique set of theoretically correct financial ratios. A manager's decisions, such as those about a company's liquidity or leverage, are not simple decisions. A business is a complex and dynamic organization. Most decisions involve some sorts of trade-offs, frequently including the Principle of Risk-Return Trade-Off. For example, a company can lower its risk by maintaining greater liquidity, but that's likely to reduce profitability. A company can lower its risk by using less debt, but that too will reduce the stockholder's expected return. Such decisions require judgment and analysis.

Likewise, an outside analyst must exercise judgment and draw on experience to understand a company's financial position. People outside the company must be aware of the possibility that managers are manipulating the company's financial information through careful decision making involving such things as choices of accounting treatments, timing of decisions and public relations. Alternative accounting treatments can alter the picture of the company's financial statements. A certain amount of manipulation of financial information, which is called window dressing, is legally permissible and fairly routine. As an outside user of financial information, you should be carefully skeptical. If you are providing financial information about your company, you should recall our admonition about ethics. Avoid unethical manipulations. They can be fraudulent and land you in prison!

Corporate practice must deal with ever-increasing complexity and that's part of what managers are paid for. If you're not an accounting major, you still must understand a critical mass of accounting to be an intelligent user of accounting information.

Why We Use Financial Statement Analysis

Comparing Companies Financial Ratios and financial statement analysis is useful in at least two ways. First, it provides a structure for understanding the dynamics of a company. For example, how would some event affect a company? Is it good or bad; is it significant or insignificant; how does it affect specific parts of the company? A financial framework allows you to more quickly understand the importance of new information.