What Have the Ratios Told Us?

KEY TAKEAWAYS

• 
  Two common techniques for evaluating a company’s financial performance are vertical percentage analysis and ratio analysis.
  
• 
  Vertical percentage analysis reveals the relationship of each item on the income statement to a specified base—generally sales—by expressing each item as a percentage of that base.
  
• 
  The percentages help you to analyze changes in the income statement items over time.
  
• 
  Ratios show the relationship of one number to another number—for example, gross profit to sales or net profit to total assets.
  
• 
  Ratio analysis is used to assess a company’s performance and financial condition over time and to compare one company to similar companies or to an overall industry.
  
• 
  Ratios can be divided into four categories: profit margin ratios, management efficiency ratios, management effectiveness ratios, and debt-to-equity ratios.
  
• 
  Profit margin ratios show how much of each sales dollar is left after certain costs are covered.
  
  • 
    Two common profitability ratios are the gross profit margin(which shows how much of each sales dollar remains after paying for the goods sold) and net profit margin (which shows how much of each sales dollar remains after all costs are covered).
    
• 
  Management efficiency ratios tell you how efficiently your assets are being managed.
  
  • 
    One of the ratios in this category—inventory turnover—measures a firm’s efficiency in selling its inventory by looking at the relationship between sales and inventory.
    
• 
  Management effectiveness ratios tell you how effective management is at running the business and measure overall company performance by comparing net profit to some measure of the amount of capital used in the business.
  
  • 
    The return on assets ratio, for instance, compares net profit to total assets to determine whether the company generated a reasonable profit on the assets invested in it.
    
  • 
    Financial condition ratios are used to assess a firm’s financial strength.
    
• 
  The current ratio (which compares current assets to current liabilities) provides a measure of a company’s ability to meet current liabilities.
  
• 
  The debt-to-equity ratio examines the riskiness of a company’s capital structure by looking at the amount of debt that it has relative to total equity.
  
• 
  Finally, the interest coverage ratio (which measures the number of times a firm’s operating income can cover its interest expense) assesses a company’s ability to make interest payments on outstanding debt.
  

EXERCISES

1. 
   (AACSB) Analysis
   

The accountant for my company just ran into my office and told me that our gross profit margin increased while our net profit margin decreased. She also reported that while our debt-to-equity ratio increased, our interest coverage ratio decreased. She was puzzled by the apparent inconsistencies. Help her out by providing possible explanations for the behavior of these ratios.

2. 
   Which company is more likely to have the higher inventory turnover ratio: a grocery store or an automobile manufacturer? Give an explanation for your answer.
   

[1] Another way to calculate inventory turnover is to divide Cost of goods sold by inventory (rather than dividing Sales by inventory). We don’t discuss this method here because the available industry data used for comparative purposes reflect Sales rather than Cost of goods sold.

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