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Financial Ratio Analysis

It is difficult to infer organizational performance from one or two simple numbers. 
Nevertheless, in practice a number of different ratios are often calculated in strategic
planning endeavors and, taken as a whole and with some caution, these ratios do provide
some information about the relative performance of an organization.  In particular, a
careful analysis of a combination of these ratios may help you to distinguish between
firms that will eventually fail and those that will continue to survive.  Evidence suggests
that, as early as five years before a firm fails, one may be able to detect trouble from the
value of these financial ratios.1

            In this note, the basic financial ratios are reviewed, and some of the caveats
associated with using them are highlighted.  The ratios tend to be most meaningful when
they are used to compare organizations within the same broad industry, or when they are
used to make inferences about changes in a particular organization's structure over time.

LIQUIDITY RATIOS

In order to survive, firms must be able to meet their short-term obligations—pay their
creditors and repay their short-term debts.  Thus, the liquidity of the firm is one measure
of a firm's financial health.  Two measures of liquidity are in common:

Current ratio = current assets / current liabilities

  Quick ratio  = (cash + marketable securities + net receivables) / current liabilities

            The main difference between the current ratio and the quick ratio is that the latter
does not include inventories, while the former does.

            Which ratio is a better measure of a firm's short-term position?  In some ways, the
quick ratio is a more conservative standard.  If the quick ratio is greater than one, there
would seem to be no danger that the firm would not be able to meet its current
obligations.  If the quick ratio is less than one, but the current ratio is considerably above
one, the status of the firm is more complex.  In this case, the valuation of inventories and
the inventory turnover are obviously critical.

            A number of problems with inventory valuation can contaminate the current
ratio.  An obvious accounting problem occurs because organizations value inventories
using either of two methods, last in, first out (LIFO) or first in, first out (FIFO).  Under
the LIFO method, inventories are valued at their old costs.  If the organization has a
substantial quantity of inventory, some of it may be carried at relatively low cost,
assuming some inflation in overall prices.  On the other hand, if there has been technical
progress in a market and prices have been falling, the LIFO method will lead to an over-
valued inventory.  Under the FIFO method of inventory valuation, inventories are valued
at close to their current replacement cost.  Clearly, if we have firms that differ in their
accounting methods, and hold substantial inventories, comparisons of current ratios will
not be very helpful in measuring their relative strength, unless accounting differences are
adjusted for in the computations.

            A second problem with including inventories in the current ratio derives from the
difference between the inventory's accounting value, however calculated, and its
economic value.  A simple example is a firm subject to business-cycle fluctuations.  For a
firm of this sort, inventories will typically build during a downturn.  The posted market
price for the inventoried product will often not fall very much during this period;
nevertheless, the firm finds it cannot sell very much of its inventoried product at the so-
called market price.  The growing inventory is carried at the posted price, but there really
is no way that the firm could liquidate that inventory in order to meet current obligations. 
Thus, including inventories in current assets will tend to understate the precarious
financial position of firms suffering inventory buildup during downturns.

            Might we then conclude that the quick ratio is always to be preferred?  Probably
not.  If we ignore inventories, firms with readily marketable inventories, appropriately
valued, will be undeservedly penalized.  Clearly, some judicious further investigation of
the marketability of the inventories would be helpful.

            Low values for the current or quick ratios suggest that a firm may have difficulty
meeting current obligations.  Low values, however, are not always fatal.  If an
organization has good long-term prospects, it may be able to enter the capital market and
borrow against those prospects to meet current obligations.  The nature of the business
itself might also allow it to operate with a current ratio less than one.  For example, in an
operation like McDonald's, inventory turns over much more rapidly than the accounts
payable become due.  This timing difference can also allow a firm to operate with a low
current ratio.  Finally, to the extent that the current and quick ratios are helpful indexes of
a firm's financial health, they act strictly as signals of trouble at extreme rates.  Some
liquidity is useful for an organization, but a very high current ratio might suggest that the
firm is sitting around with a lot of cash because it lacks the managerial acumen to put
those resources to work.  Very low liquidity, on the other hand, is also problematic.

LEVERAGE

Firms are financed by some combination o£ debt and equity.  The right capital structure
will depend on tax policy—high corporate rates favor debt, high personal tax rates favor
equity—on bankruptcy costs, and on overall corporate risk.  In particular, if we are
concerned about bankruptcy possibilities, the long-run solvency or leverage of the firm
may be important.  There are two commonly used measures of leverage, the debt-to-
assets ratio and the debt-equity ratio;

            Debt-to-asset ratio = total liabilities / total assets

              Debt-equity ratio = long-term debt / shareholder's equity

            As with liquidity measures, problems in measurement and interpretation also

occur in leverage measures.  The central problem is that assets and equity are typically
measured in terms of the carrying (book) value in the firm's financial statements.  This
figure, however, often has very little to do with the market value of the firm, or the value
that creditors could receive were the firm liquidated.

            Debt-to-equity ratios vary considerably across industries, in large measure due to
other characteristics of the industry and its environment.  A utility, for example, which is
a stable business, can comfortably operate with a relatively high debt-equity ratio.  A
more cyclical business, like manufacturing of recreational vehicles, typically needs a
lower D/E—a reminder that cross-industry comparisons of these ratios is typically not
very helpful.

            Often, analysts look at the debt-equity ratio to determine the ability of an
organization to generate new funds from the capital market.  An organization with
considerable debt is often thought to have little new-financing capacity.  Of course, the
overall financing capacity of an organization probably has as much to do with the quality
of the new product the organization wishes to pursue as with its financial structure. 
Nevertheless, given the threat of bankruptcy and the attendant costs, a very high debt-
equity ratio may make future financing difficult.  It has been argued, for example, that
railroads in the 1970s found it hard to find funds for new investments in piggybacking, a
large technical improvement in railroading, because the threat of bankruptcy from prior
poor investments was so high.

RATES OF RETURN

            There are two measures of profitability common in the financial community,
return on assets (ROA) and return on equity (ROE).

                        ROA = net income / total average assets

                        ROE = net income / total stockholders equity

            Assets and equity, as used in these two common indexes, are both measured in
terms of book value.  Thus, if assets were acquired some time ago at a low price, the
current performance of the organization may be overstated by the use of historically
valued denominators.  As a result, the accounting returns for any investment generally do
not correlate well with the true economic internal rate of return for that investment.

            Difficulties with using either ROA and ROE as a performance measure can be
seen in merger transactions.  Suppose we have an organization that has been earning a net
income of $500 on assets with a book value of $1000, for a hefty ROA of 50 percent. 
That organization is now acquired by a second firm, which then moves the new assets
onto its books at the acquisition price, assuming the acquisition is treated using the
purchase method of accounting.  Of course, the acquisition price will be considerably
above the $1,000 book value of assets, for the potential acquirer will have to pay hand-
somely for the privilege of earning $500 on a regular basis.  Suppose the acquirer pays
$2,000 for the assets.  After the acquisition, it will appear that the returns of the acquired
firm have fallen.  The firm continues to earn $500, but the asset base is now $2,000, so
the ROA is reduced to 25 percent.  Indeed, the ROA may be less as a result of other
factors, such as increased depreciation of the newly acquired assets.  Yet in fact nothing
has happened to the earnings of the firm.  All that has changed is its accounting, not its
performance.

            Another fundamental problem with ROA and ROE measures comes from the
tendency of analysts to focus on performance in single years, years that may be
idiosyncratic.  At a minimum, one should examine these ratios averaging over a number
of years to isolate idiosyncratic returns and try to find patterns in the data.

STOCK MARKET RATIOS

Several ratios are calculated not from the income statements and balance sheets of
organizations, but from data associated with their stock market performance.  The three
most common ratios are earnings per share (EPS), the price-earnings ratio (P/E), and the
dividend-yield ratio:

                             EPS = (net income - preferred dividends) /

                                         common shares outstanding

                              P/E = market price per share / earnings per share

            Dividend yield = annual dividends / price per share

            EPS is one of the most widely used statistics.  Indeed, it is required to be given in
the income statements of publicly traded firms.  As we can see, the ratio tells us how
much the firm has earned per share of stock outstanding.  As it turns out, this is not
generally a very helpful statistic.  It says nothing about how many assets a firm used to
generate those earnings, and hence nothing about profitability.  Nor does it tell us how
much the individual stockholder has paid per share for the rights over that annual
earning.  Further, accounting practices in the calculation of earnings may distort these ra-
tios.  And finally, the treatment of inventories is again problematic.

            The P/E is another ratio commonly cited.  Indeed, P/Es are reported in daily
newspapers.  A high P/E tends to indicate that investors believe the future prospects of
the firm are better than its current performance.  They are in some sense paying more per
share than the firm's current earnings warrant.  Again, earnings are treated differently in
different accounting practices.

            Finally, from the perspective of some stockholders at least, dividend policy may
be important.  The dividend-yield ratio tells us how much of its earnings the firm pays
out in dividends versus reinvestment.  Rapidly growing firms in new areas tend to have
low dividend-yield ratios; more mature firms tend to have higher ratios.

SUMMARY

In this note, we have briefly reviewed a variety of ratios commonly used in strategic
planning.  All of these ratios are subject to manipulation through opportunistic
accounting practices.  Nevertheless, taken as a group and used judiciously, they may help
to identify firms or business units in particular trouble.  Finding profitable new ventures
requires rather more work.