Ratio Analysis

Recall that financial ratios express one financial quantity concerning another and can be used to evaluate a company’s performance over time. By reducing the effect of company size, ratios can also enhance comparison between companies.

Financial Ratio Relationships

It is crucial to examine a variety of financial ratios rather than focusing on a single ratio or category in isolation to understand a company’s overall position and performance. Experience indicates that insights from one ratio category can clarify questions raised by another. The most accurate overall picture emerges by integrating information from all sources, providing a comprehensive understanding of the company’s financial health.

Consider the following example.

Example: Contradicting Liquidity Ratios

An analyst is assessing the liquidity of Maple Manufacturing, a Norwegian manufacturing company, and gathers the liquidity ratios and activity ratios shown below:

$$\begin{array}{l|c|c|c}
\textbf{Ratio} & \textbf{2023} & \textbf{2022} & \textbf{2021} \\ \hline
\text{Current Ratio} & 2.1 & 1.9 & 1.6 \\ \hline
\text{Quick Ratio} & 0.8 & 0.9 & 1.0 \\ \hline
\text{Days of Inventory Held (DOH)} & 55 & 45 & 30 \\ \hline
\text{Days Sales Outstanding (DSO)} & 24 & 28 & 30 \\
\end{array}$$

Which of the following best explains the observed change in Maple Manufacturing’s liquidity ratios from 2021 to 2023?

1. The company increased its cash holdings.
2. The company improved its sales significantly.
3. The company used proceeds from receivables to purchase inventory.

Solution

The correct answer is C.

The ratios present a conflicting view of the company’s liquidity. Based on the increase in its current ratio from 1.6 to 2.1, the company appears to have strong and improving liquidity; however, the decline in the quick ratio from 1.0 to 0.8 suggests that its liquidity is deteriorating. Since both ratios use current liabilities as the denominator, the difference must be due to changes in an asset included in the current ratio but not in the quick ratio, such as inventories.

The company’s DOH has increased from 30 days to 55 days, indicating that the company is holding larger amounts of inventory relative to sales. Meanwhile, the decrease in DSO implies that the company is collecting receivables faster. If the proceeds from these collections were held as cash, there would be no effect on either the current ratio or the quick ratio. However, if the proceeds were used to purchase inventory, there would be no effect on the current ratio, but the quick ratio would decline, which matches the observed pattern.

Collectively, these ratios suggest that liquidity is declining and that the company may need to address an inventory management issue.

A is incorrect. If the company increased its cash holdings, both the current ratio and the quick ratio would improve.

B is incorrect. Improved sales might affect inventory levels and receivables, but the observed pattern in the liquidity ratios is not directly explained.

Question 1

Which of the following statements is least likely accurate?

1. It is necessary to use averages whenever only balance sheet items are included in a ratio.
2. Evaluating a ratio’s numerator and denominator can help determine what the ratio is attempting to measure and how it should be interpreted.
3. Whenever an income statement item is represented in the numerator, and a balance sheet item is represented in the denominator of a ratio, it is advisable to use an average value of the balance sheet item in the denominator.

Solution

The correct answer is A.

It is unnecessary to use averages whenever only balance sheet items are included in a ratio, as both should have been determined on the same date. Both statements in B and C are accurate.

Question 2

Xena Corp reported the following information in its latest financial reports:

Inventory turnover at the beginning of the period: 10

Inventory turnover at the end of the period: 12

Gross profit margin: 30%(same as last year)

Revenue: $3,000,000M (same as last year)

What conclusion can you most likely make out of this information?

1. The company decreased its inventory.
2. The company increased the total cost of goods sold.
3. The total cost of goods sold for the company remained constant.

Solution

The correct answer is A.

Considering that the inventory turnover ratio has changed, the company must have either increased the total cost of goods sold or decreased the held inventory during the period. The company’s revenue and gross profit margin remained constant during the period, so it must have decreased its holding inventory.