Foundations of Financial Management: An Analysis (part 8)

Beware of little expenses. A small leak will sink a great ship.

Benjamin Franklin

Financial Analysis

by

Charles Lamson

Ratio Analysis

Ratios are used in much of our daily life. We buy cars based on miles per gallon; we evaluate baseball players by earned-run and batting averages, basketball players by field goal and foul-shooting percentages, and so on. These are all ratios constructed to judge comparative performance. Financial ratios serve a similar purpose, but you must know what is being measured to construct a ratio and to understand the significance of the resultant number.

Financial ratios are used to weigh and evaluate the operating performance of the firm. While an absolute value such as earnings of $50,000 or accounts receivable of $100,000 may appear satisfactory, its acceptability can be measured only in relation to other values. For this reason, financial managers emphasize ratio analysis.

For example, are earnings of $50,000 actually good? If we earned $50,000 on $500,000 of sales (10 percent "profit margin" ratio), that might be quite satisfactory---whereas earnings of $50,000 on $5,000,000 could be disappointing (a meager 1 percent return). After we have computed the appropriate ratio, we must compare our results to those achieved by similar firms in our industry, as well as to our own performance record. Even then, this "number-crunching" process is not fully adequate, and we are forced to supplement our financial findings with an evaluation of company management, physical facilities, and numerous other factors.

Classification system

We will separate 13 significant ratios into four primary categories. 

The first grouping, profitability ratios, allows us to measure the ability of the firm to earn an adequate return on sales, total assets, and invested capital. Many of the problems related to profitability can be explained, in whole or in part, by the firm's ability to effectively employ its resources. Thus the next category is asset utilization ratios. Under this heading, we measure the speed at which the firm is turning over accounts receivable, inventory, and longer-term assets. In other words, asset utilization ratios measure how many times per year a company sells its inventory or collects all of its accounts receivable. For long-term assets, the utilization ratio tells us how productive the fixed assets are in terms of generating sales.

In category C, the liquidity ratios, the primary emphasis moves to the firm's ability to pay off short-term obligations as they come due. In category D, debt utilization ratios, the overall debt position of the firm is evaluated in light of its asset base and earning power.

The users of financial statements will attach different degrees of importance to the four categories of ratios. To the potential investor or a security analyst, the critical consideration is profitability, with secondary consideration given to such matters as liquidity and that utilization. For the banker or trade creditor, the emphasis shifts to the firm's current ability to meet debt obligations. The bondholder, in turn, may be primarily influenced by debt to total assets while, also eyeing the profitability of the firm in terms of its ability to cover debt obligations. Of course, the experienced analyst looks at all ratios, but with different degrees of attention.

Ratios are also important to people in the various functional areas of a business. The marketing manager, the head of production, the human resource manager, and so on, must all be familiar with ratio analysis. For example, the marketing manager must keep a close eye on inventory turnover, the production manager must evaluate the return on assets and the human resource manager must look at the effect of fringe benefits expenditures on the return on sales.

The Analysis

Definitions alone carry little meaning in analyzing or dissecting the financial performance of a company. For this reason, we shall apply our four categories of ratios to a hypothetical firm, the Lamson Company, as presented in Table 1. The use of ratio analysis is rather like solving a mystery in which each clue leads to a new area of inquiry.

Table 1 Financial statement for ratio analysis

A. Profitability Ratios We first look at profitability ratios. The appropriate ratio is computed for the Lamson Company and is then compared to representative industry data.

Profitability Ratios---

In analyzing the profitability ratios, we see the Lamson Company shows a lower return on the sales dollar (5.9 percent) than the industry average of 6.7 percent. However, its return on assets (investment) of 14.8 percent exceeds the industry norm of 10%. There is only one possible explanation for this occurrence---a more rapid turnover of assets than that is generally found within the industry. This is verified ratio 2b, in which sales to total assets is 2.5 for the Lamson Company and only 1.5 for the industry. Thus Lamson earns less on each sales dollar, but it compensates by turning over its assets more rapidly (generating more sales per dollar of assets).

Return on total assets as described through the two components of profit margin and asset turnover is part of the DuPont system of analysis.

Return on assets (investment equals) = Profit margin X Asset turnover

The DuPont company was a forerunner in stressing that satisfactory return on assets may be achieved through prophet high profit margins or rapid turnover of assets, or a combination of both. We shall also soon observe that under the DuPont system of analysis, the use of debt may be important. The DuPont system causes the analyst to examine the sources of a company's profitability. Since the profit margin is an income statement ratio, a high profit margin indicates good cost control, whereas a high asset turnover ratio demonstrates efficient use of the assets on the balance sheet. Different industries have different operating and financial structures. For example, in the heavy capital goods industry the emphasis is on a high profit margin with a low asset turnover whereas in food processing, the profit margin is low and the key to satisfactory returns on total assets is a rapid turnover of assets.

Equally important to a firm is its return on equity or ownership of capital. For the Lamson Company, return on equity is 23.7 percent, versus an industry norm of 15 percent. Thus the owners of Lamson Company are more amply rewarded than are other shareholders in the industry. This may be the result of one or two factors: a high return on total assets or a generous utilization of debt or a combination thereof. This can be seen through Equation 3b, which represents a modified or second version of the DuPont formula.

Note the numerator, return on assets, is taken from Formula 2, which represents the initial version of the DuPont formula (Return on assets = Net income/Sales X Sales/Total assets). Return on assets is then divided by [1 - (Debt/Assets)] to account for the amount of debt in the capital structure. In the case of the Lamson Company, the modified version of the DuPont formula shows:

Actually the return on assets of 14.8 percent in the numerator is higher than the industry average of 10 percent, and the ratio of debt to assets in the denominator of 37.5 percent is higher than the industry norm of 33 percent. Both the numerator and denominator combined contribute to a higher return on equity than the industry average (23.7 percent versus 15 percent). Note that if the firm had a 50% debt to assets ratio, return on equity would go up to 29.6%.

This does not necessarily mean that is a positive influence, only that it can be used to boost return on equity. The ultimate goal for the firm is to achieve maximum valuation for its securities in the marketplace, and this goal may or may not be advanced by using debt to increase return on equity. Because that represents increased risk, a lower valuation of higher earnings is possible. Every situation must be evaluated individually.

Finally as a general statement in computing all the profitable ratios, the analyst must be sensitive to the age of the assets. Plant and equipment purchased 15 years ago may be carried on the books far below its replacement value in an inflationary economy. A 20 percent return on assets purchased in the 1990s may be inferior to a 15 percent return on newly purchased assets.

B. Asset Utilization Ratios The second category of ratios relates to asset utilization, and the ratios in this category may explain why one firm can turn over its assets more rapidly than another. Notice that all of these ratios relate the balance sheet (assets) to the income statement (sales). The Lamson Company's rapid turnover of assets is primarily explained in ratios 4, 5, and 6.

Asset Utilization Ratios---

Lamson collects its receivables faster than does the industry. This is shown by the receivables turnover of 11.4 times versus 10 times for the industry, and in daily terms by the average collection period of 32 days, which is four days faster than the industry norm. The average collection period suggests how long, on average, customers accounts stay on the books. The Lamson Company has $350,000 in accounts receivable and four million dollars in credit sales, which when divided by 360 days (used in finance and business calculations as opposed to 365 days for the sake of simplicity) yields average daily credit sales of $11,111. We divide accounts receivable of $350,000 by average daily credit sales of $11,111 to determine how many days credit sales are on the books (32 days).

In addition the firm turns over its inventory 10.8 times per year as contrasted with an industry average of 7 times. This tells us that Lamson generates more sales per dollar of inventory than the average company in the industry, and we can assume the firm uses very efficient inventory ordering and cost control methods.

The firm maintains a slightly lower ratio of sales to fixed assets (plant and equipment) than does the industry (5 versus 5.4) as shown above. This is a relatively minor consideration in view of the rapid movement of inventory and accounts receivable. Finally, the rapid turnover of total assets is again indicated (2.5 vs 1.5).

C. Liquidity Ratios After considering profitability and asset utilization, the analyst needs to examine the liquidity of the firm. The Lamson Company's liquidity ratios fare well in comparison with the industry. Further analysis might call for a cash budget to determine if the firm can meet each maturing obligation as it comes due.

Liquidity Ratios---

D. Debt Utilization Ratios The last grouping of ratios, debt utilization, allows the analyst to measure the prudence of the debt management policies of the firm.

Debt to total assets of 37.5 percent as shown in the Equation 11 is slightly above the industry average of 33 percent, but well within the prudent range of 50 percent or less.

Debt Utilization Ratios---

Ratios for times interest earned and a fixed charge coverage show that the Lamson Company debt is being well-managed compared to the debt management firms in the industry. Times interest earned indicates the number of times that income before interest and taxes covers the interest obligation (11 times). The higher the ratio, the stronger is the interest paying ability of the firm. The figure for income before interest and taxes ($550,000) in the ratio is the equivalent of the operating profit figure presented in the upper part of Table 1 presented previously in this post.

Fixed charge coverage measures the firm's ability to meet all fixed obligations rather than interest payments alone, on the assumption that failure to meet any financial obligation will endanger the position of the firm. In the present case the Lamson Company has lease obligations of $50,000 as well as the $50,000 in interest expenses. Thus the total fixed charge financial obligation is $100,000. We also need to know the income before all fixed charge obligations. In this case we take income before interest and taxes (operating profit) and add back the $50,000 and lease payments.

The fixed charges are safely covered 6 times, exceeding the industry norm of 5.5 times. The various ratios are summarized in Table 2 on page. The conclusions reached in comparing the Lamson Company to industry averages are generally valid, though exceptions may exist. For example, a high inventory turnover is considered good unless it is achieved by maintaining unusually low inventory levels, which may hurt future sales and profitability.

In summary, the Lamson Company more than compensates for a lower return on the sales dollar by the rapid turnover of assets, principally inventory and receivables, and a wise use of debt. You should be able to use these 13 measures to evaluate the financial performance of any firm. 

*MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED., PP. 53-61*

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