5.3 Financial Ratios
Ratio analysis is fundamental to finance, and ratios are regularly used in this discipline. Ratios are basic tools of analysis. It is very important, therefore, that you master the following.
It is important to understand that ratios do not provide answers, but instead raise questions, which the analyst must then resolve. Questions raised must be investigated. Analyst speculations should be based on knowledge of financial statements, the macroeconomic and industry backgrounds in which the company operates, management profiles, and company history. The ratios themselves are derived from accounting data, which are subject to interpretive issues.
A ratio consists of two numbers, which are compared to one another. “2:1” (two-to-one) or “1:3” are ratios. In fact, any simple number is a ratio because it can always be compared to one! Fractional numbers also pertain. We may also think of ratios as consisting of a numerator (on the top) and a denominator (on the bottom), e.g., 2/1 and 1/3 above.
No (financial) ratio means anything by itself – it must be compared to some other datum in order to derive inferences. The means by which the comparison may be made are:
Longitudinal (Vertical): This would involve comparing a ratio for a company at two different points in time. For instance, we may say that IBM’s profit margin last year was 10% versus this year’s 20%. What are the relevant trends? Longitudinal analysis data can be effectively diagrammed.
Cross-Sectional (Horizontal): here we would compare two companies on the basis of a selected ratio at the same point in time. This might lead us to conclude, for instance, that one company is more profitable than another at present.
At times, the construction of a financial ratio may involve comparing a Balance Sheet datum with an Income Statement number. This presents a problem in that the former statement is a static, or “as-of” based statement, whereas the latter is a flow, or moving picture. In order to compare apples to apples, i.e., when comparing an Income Statement with a Balance Sheet number, the analyst may choose to use an average number for the Balance Sheet datum in order to make the Balance Sheet number appear more like a “flow.” The average may be calculated in various ways, e.g., by averaging two consecutive year-end data, using quarterlies, or, if available, monthlies.
Averaging may be especially warranted in cases where balance sheet data fluctuate widely due to seasonality or other factors. For example, a snow-mobile manufacturer may have much inventory in September and far less inventory in March. In such a case, it may be advised for the analyst to average the inventory number over, say, four quarters. In the pages to follow, we will learn how this averaging is actually done by the analyst – and under what circumstances.
Below are some important financial ratios, listed by category. When would you utilize certain ratios? How may your choice of ratio vary from sector to sector (or industry to industry)? In many, if not most, instances there is no universal – minimum, maximum or average – “ideal” ratio that relates to all situations. The ideal ratio, if there is such a thing, is a function of numerous variables, including the nature of the industry, the company, the management risk profile, and perhaps the shareholders’ risk profiles and goals as well.
As we go through the discussion regarding Ratio Analysis, some of you may wish to calculate the generic ratios provided using an example. At the end of Chapter Seven, the reader will find a page entitled “Simple Ratio Analysis Exercise.” That page contains a Balance Sheet and Income Statement for a fictitious company; a ratios worksheet follows on the subsequent page, with the solutions following that page. You may work through the ratios there.
Keep in mind that the actual ratios’ arithmetic calculations are secondary to the primary and underlying understanding of what the actual ratios are in the abstract, and what they mean. Once you understand the ratios themselves, e.g., what it means when we say that “average collections are 32 days,” or that the TIE Ratio should exceed one, the calculations become a matter of a simple arithmetic exercise, a mere changing of the inputted numbers to fixed formulae. That said, you will find a comprehensive exercise, including a Balance Sheet and Income Statement, requiring the calculation of all our Financial Ratios below – in Section #7.5. As you calculate, don’t forget the numerous faults with accounting data!