LAS FUNCIONES

With an understanding of how accountants create their financial statements, let me add some tools to interpret them: ratios. Absolute numbers in a financial statement in and of themselves often are of limited significance. The real information can be found in an analy-sis of the relationship of one number to another or of one company to another in the same industry—using ratios. In the grocery game, profits are usually low in relation to sales, so grocers must sell in large volume to make any real profit. A jewelry store survives on slower-paced sales but higher profits per item. That is why ratios are used to compare performances among companies within an industry and against a company’s own historical performance.

There are four major categories of ratios:

Liquidity measures: How much is on hand that can be converted to cash to pay the bills?

Capitalization measures: Is a company heavily burdened with debt? Are its investors financing the company? How is the company funding itself?

Activity measures: How actively are the firm’s assets being deployed? (MBAs deploy assets, rather than just use them.)

Profitability measures: How profitable is a company in relation to the assets and the sales that made its profits possible?

There are literally hundreds of possible ratios, but most have their origin in eight basic ratios from the four categories listed above.

Using Bob’s financial statements, I have calculated these eight ratios for his operation and have placed them below each of the ratio explanations.

LIQUIDITY RATIOS

1. Current Ratio = Current Assets / Current Liabilities

Can the company pay its bills comfortably? A ratio greater than 1 shows liquidity. It shows that there is leeway in the current assets available to pay for current liabilities.

$115,000

= 1.32

)

(

CAPITALIZATION RATIOS

2. Financial Leverage = (Total Liabilities + Owners’ Equity) / OE

$142,000

= 3.155

) (

When a company assumes a larger proportion of debt than the amount invested by its owners, it is said to be leveraged. In a profitable company, by using a higher level of debt, the return is much higher because a smaller amount appears in the denominator of the ratio. The “same” amount of earnings is divided by a smaller equity base. Ratios of greater than 2 show an extensive use of debt.

I will explain leverage more fully when discussing the profitability ratios.

3. Long-Term Debt to Capital = Long-Term Debt / (Liabilities + ^OE)

$10,000

= .07 = 7%

) (

Because debt payments are fixed obligations that must be paid while dividends to investors are not, the level of debt is an important measure of a company’s riskiness. A ratio of greater than 50 percent shows a high level of debt. Depending on the timing and stability of a firm’s cash flows, 50 percent could be considered risky. Stable elec-tric utilities have predictable sales and cash flows; therefore, ratios over 50 percent are commonplace. Investment analysts on Wall Street consider those debt levels conservative.

ACTIVITY RATIOS

4. Assets Turnover per Period = Sales / Total Assets

$5,200,000

= 36.6 turns

) (

This ratio tells the reader how actively the firm uses all of its as-sets. The firm that can generate more sales with a given set of assets is said to have managed its assets efficiently. Ratios are industry-specific. Thirty-six is a high turnover of assets for most industries, but for an antique shop a turnover of three may be considered high.

One-of-a-kind antiques sit waiting for the right collector to come along. In the grocery trade 36.6 turns per year is normal because the shelf inventory of a supermarket is sold about every week. The pro-duce, milk, and toilet paper inventory turn over several times a week, while the exotic spices take much longer to sell.

5. Inventory Turns per Period = Cost of Goods Sold / Average Inventory Held During the Period

(A simple way to calculate “average inventory” is by adding the beginning and ending inventory balances, then dividing by two.)

$3,900,000

= 39 turns per year

)

(

6. Days Sales in Inventory = Ending Inventory / (Cost of Goods Sold / 365)

$100,000

= 9.36 days

) (

These two activity ratios show how actively a company’s inven-tory is being deployed. Is inveninven-tory sitting around collecting dust or is it being sold as soon as it hits the shelf? In a high-turnover busi-ness, like the grocery trade, there are many turns of inventory during a year and only a few days of inventory on hand. Most grocery items are perishable and purchased frequently.

PROFITABILITY RATIOS

7. Return on Sales (ROS) = Net Income / Sales

$30,000

= .005769 = .58%

) (

“Return” ratios are easy to calculate and investment analysts use them frequently. They calculate the return on just about any part of the balance sheet and income statement. Another common one is the return on assets (ROA).

8. Return on Equity (ROE) = Net Income / Owners’ Equity

$30,000

= .6667 = 67%

) (

The mix of debt and equity can dramatically affect the ratios. If a company has a high level of debt and a small amount of equity, the return on equity (ROE) can be tremendously affected. That is called financial leverage, the term that I mentioned before in discussing capitalization ratios. To illustrate the point, Bob and his father could

have decided to leave very little equity in the company in 2005. They could have taken all of the $30,000 of net income made in 2005 out of the company as dividends and borrowed for their future cash needs. If that had happened, the balance sheet would have reflected a long-term debt balance of $40,000 ($10,000 + $30,000) and only

$15,000 ($45,000 $30,000) in equity. The resulting debt to equity ratio would increase from 7 percent to 28 percent, and the return on equity would have increased from 67 percent to 200 percent ($30,000/$15,000). As shown, ratios can be greatly affected by the financial leverage used. The choice of a lower equity level can “lever-age” the ROE to extremely high levels.

ROE ratio is a widely accepted yardstick to measure success. In Forbes’s “Annual Report of American Industry,” companies with the greater ROEs were ranked higher than many of their more profitable counterparts simply because of their financing choices. If management’s goal is to achieve a higher profitability ratio through leverage, there is a risk cost. Higher debt levels require higher inter-est payments that a company may not be able to service if operations do poorly. The corporate failures in the 1990s of Revco Drugs, Southland’s 7-Eleven, and Federated Department Stores were cases in which management risked bankruptcy with high leverage and lost.

THE DU PONT CHART

Academics have a tendency to give imposing names to simple con-cepts. Your MBA vocabulary would not be complete without includ-ing the Du Pont Chart. The chart shows how several of the most important financial statement ratios are related to one another by displaying their components.

By charting the interrelationships among ratios, one can see that changes in a component of one ratio affect the other ratios. The ra-tios share the same inputs. For example, when Total Assets is re-duced, both the Asset Turnover and Return on Assets ratios increase because Total Assets are included in the calculation of both of those

ratios as a denominator. Conversely, a reduction of Total Assets (equal to total liabilities and owners’ equity) decreases Financial Leverage as it is used in that ratio’s numerator.

RATIOS ARE INDUSTRY-SPECIFIC

Profitability is, as in the case of all other ratios, industry-specific.

Every industry has a profit level depending on the physical demands of the industry. Heavy manufacturers such as steel makers have a re-turn on assets (ROA) of less than 10 percent. They have large steel mills and a great deal of factory equipment. Service businesses such as profitable headhunting firms may have ROAs over 100 percent.

The only assets they need are cash, office furniture, and customer re-ceivables. Their real asset is their staff’s talent for nursing and per-suading, which cannot be quantified on the balance sheet.

Profitability also depends on the level of competition. In the gro-cery business, intense competition keeps the return on sales to a low 1 percent. During Bob’s first year he had a .58 percent return, which was below the industry average. Considering that it was his first year, any profit should be commended.

Any part of the financial statements can be compared to another with a ratio of some sort. Any calculator can divide one number by another. Only those ratios that can provide some insight into a busi-ness’s performance are valuable. The true value of ratios is seen when one firm’s ratios are compared to those of another in the same industry, or to that firm’s historical performance. Alternatively the

“attractiveness” of various industries as business opportunities may be explored by comparing their averages. Each firm and industry has its own key operating statistics that are meaningful.

For industry-specific references on all these ratios, Robert Mor-ris Associates publishes its Annual Statement Studies. This valuable reference book, available in most libraries, includes financial and operating ratios for over three hundred manufacturers, wholesalers, retailers, services, contractors, and finance companies.