Later when she had calmed down, she approached her father and asked why he had turned her down in her bid to lead the company. His answer was simple and direct: “You cannot read financial statements.” He went on to say, “Without this ability, you will not be able to manage the company well enough to keep it on track with the requirements of its banks, nor will you be able to assure that the customers would pay their bills appropriately and that the company would pay its bills in the most efficient manner. You would not have any idea about how to give credit terms or take advantage of terms offered by the firm's suppliers. You would not know what the impact of production scheduling changes or capital purchases would have on the firm and would thus not know the impact of any decisions you made in these areas. In short, if you can't read the financial statements, you won't know how to manage the firm's cash flow and, ultimately, you would not be able to keep the company on an even financial keel.”
Sydney wanted to know how she could learn to “read financial statements.” Her father suggested two things: (1) learn about the firm's financial statements and (2) understand ratio analysis.
Chapter 3 indicated the role that financial statements play in providing relevant and timely information about the overall health of the company to entrepreneurs, investors, and other stakeholders. Financial statements provide a wealth of information that can be used to assess the risk of the firm, evaluate management's efficiency, and determine future needs of capital. However, it is sometimes difficult to interpret all this information without first putting it into context. For example, suppose a firm has total assets of $1,250,000 on the balance sheet. Is this good, bad, or neither? Is the firm going in the right or wrong direction? Based on this number alone, it's hard to tell. By looking at the financial statement in isolation, it can be difficult to get a clear picture of how the firm's performance is progressing over time and how the firm compares to its peers. Financial ratio analysis helps make sense of this problem by providing a method for making better use of the information in the financial statement. It is an extremely useful management tool that improves the understanding of financial results and trends over time and provides key indicators of organizational performance. In this chapter, we will look at how we can use financial ratios to perform a complete and efficient analysis of the firm. Chart 4.1 presents a schematic representation of the material covered in this chapter.
Chart 4.1 Schematic of Chapter 4
Uses of Financial Ratios
Before delving into the ratios themselves, we must first understand how we can use ratios in the business environment. Like financial statements, financial ratios are not very useful on a stand-alone basis; they must be benchmarked against something. The two benchmarks useful for financial ratios are comparing the firm to its own past performance (time-series) or against other companies (cross-sectional). While the computation and ratios don't change in either form of use, each context of use provides a different perspective and benefit.
Time-Series
The time-series benchmark of the financial ratios is used to assess the trends at the company over a specific time frame. This allows the entrepreneur to see how his or her firm's operations are progressing throughout the time period being analyzed. An examination of the ratios at different points in time can help identify if the firm is headed in the right direction; if the ratios are improving, then management is doing a good job in running the firm. Conversely, deterioration in the ratios from period to period can help identify areas in the management of the firm that are causes for concern.
Cross-Sectional
While the time-series approach compares the firm to itself at different points in time, the cross-sectional benchmark approach compares the firm to two or more companies at a specific point in time. Unless it's a monopoly, a firm does not operate in isolation; it operates in a competitive environment. If the firm cannot operate with the same efficiency as its competitors, it risks having financial difficulties and eventually being insolvent. By comparing the financial ratios of the firm against other firms or the industry, investors and management can get a better idea of what management's and the firm's strengths and weaknesses are in relation to its peers.
Sources of Information
In time-series ratio analysis, the most important source of information is the firm's historical financial statements, as these are the ones that will reveal the trends within the firm's operations. While the firm's balance sheet, income statement, and statement of cash flows are the major sources of information, it's also important to look elsewhere in the financial statements for other pieces of data needed to calculate the ratios. For example, lease payment amounts, needed to calculate the fixed charges coverage ratio (discussed later in the chapter), are usually lumped into the sales, general, and administration (SG&A) expenses in the income statement. Often small details like this will have to be researched by the analyst to perform a complete analysis.
In a cross-sectional ratio analysis, not only are the firm's financial statements needed, but information from the industry and other competitors is also required. Many publications provide financial ratios for various industries and individual companies. Financial ratios for industries are published each census period by the U.S. Department of Commerce at www.commerce.gov. The Almanac of Business and Industrial Financial Ratios provides an annual publication of industry ratios by the North American Industry Classification System (NAICS). Individual company ratios can be found on the web by companies such as Fintel, Standard & Poor's, Bloomberg, and Hoover's.
For demonstration purposes, we will be calculating each of the 2013 financial ratios discussed (except for market ratios) for Old Pueblo Lithographers (OPL) based on the information provided by its financial statements included in the Appendix (Balance Sheet, Income Statement, and Statement of Cash Flows) at the end of this chapter. A summary of all financial ratios for 2012 and 2013, as well as industry averages for 2013, is included in Table 4.1 in the summary section of this chapter.
Types of Ratios
Ratios can be classified in terms of the information they provide to the reader. This means that analysis of the different types of ratios helps identify certain aspects of performance for the firm. Chart 4.2 provides a graphic view of the five types of ratios.
Chart 4.2 Types of Ratios
Liquidity
These types of ratios may be used to analyze the firm's financial ability to meet short-term liabilities. This form of liquidity analysis focuses on the relationship between current assets and current liabilities, as well as the speed with which receivables and inventory can be converted into cash during normal business operations. This class of ratios is particularly important to bankers. Liquidity ratios in general are used extensively to qualify loan applicants for loans. Bankers view both the trend and the point-in-time peer group comparative measurements to be important.
The two most common measurements are the current ratio and the quick ratio. The current ratio is the ratio of current assets to current liabilities: