Relationships among Ratios

Financial ratios express one financial quantity in relation to another and can be used to evaluate the performance of a company over time. By reducing the effect of company size, ratios can also enhance a comparison being made between companies.

Evaluating the numerator and denominator of a ratio can help to determine what the ratio is attempting to measure and how it should be interpreted.

Financial Ratio Relationships

Some financial ratios involve the use of balance sheet items only, some involve income statement items only, while some involve a combination of items from different financial statements.

Generally speaking, whenever an income statement or cash flow statement item is represented in the numerator of a ratio and a balance sheet item is represented in the denominator, it is best to use an average value of the balance sheet item in the denominator. For example, Return on Equity (ROE) is computed as Net income/Average total equity. Similarly, Return on Assets (ROA) is computed as Net income/Average total assets.

It is however not necessary to use averages whenever only balance sheet items are included in the ratio as both items should be determined at the same date. For example, the current ratio is computed as Current assets/Current liabilities.

It is important to examine a variety of financial ratios and not just a single ratio or category of ratios in isolation. This helps with ascertaining the overall financial position of a company as well as its performance over time.

Evaluation of a Company Using Ratio Analysis

The following information on a company is provided for the periods ended December 31, 2015, and December 31, 2016.

$$ \begin{array}{|c|c|c|} \hline \textbf{Ratios} & \textbf{December 31,2016} & \textbf{December 31,2015} \\ \hline \text{Return on Equity} & {5.75\%} & {4.12\%} \\ \hline \text{Return on Assets} & {3.17\%} & {2.98\%} \\ \hline \text{Current ratio} & {2.1} & {1.5} \\ \hline \text{Inventory turnover} & {35.8} & {31.7} \\ \hline \text{Net profit margin} & {3.23\%} & {1.56\%} \\ \hline \text{Debt-to-assets} & {56.23\%} & {65.00\%} \\ \hline \end{array} $$

The table demonstrates that overall, the company’s performance improved from 2015 to 2016. This is highlighted by:

  • An increase in profitability which is indicated by increases in the values of the ROE, ROA, and net profit margin ratios;
  • An increase in liquidity as indicated by the increase in the current ratio;
  • An increase in asset utilization as evidenced by the increase in the inventory turnover ratio; and
  • Stronger solvency as evidenced by the decrease in the debt-to-assets ratio

Question 1

Which of the following statements is least likely accurate?

A. 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 best to use an average value of the balance sheet item in the denominator.

B. It is necessary to use averages whenever only balance sheet items are included in a ratio.

C. Evaluating the numerator and denominator of a ratio can help to determine what the ratio is attempting to measure and how it should be interpreted.

Solution

The correct answer is B.

It is not necessary to use averages whenever only balance sheet items are included in a ratio as both items should have been determined at the same date. Both other statements are correct.

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%

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

What can you most likely conclude out of this information?

A. The company decreased its inventory.

B. The company increased the total cost of goods sold.

C. None of the above.

Solution

The correct answer is A.

As 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. As the company’s revenue and gross profit margin both remained constant during the period, the company must have decreased its holding inventory.

Reading 24 LOS 24c:

Describe relationships among ratios and evaluate a company using ratio analysis


Financial Reporting and Analysis – Learning Sessions

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