RATIOS AND THEIR CLASSIFICATION

RATIOS AND THEIR CLASSIFICATION

A ratio is a mathematical relation between two quantities. Suppose you have 200 apples and 100 oranges. The ratio of apples to oranges is 200/ 100, which we can conveniently express as 2:1 or 2. A financial ratio is

a comparison between one bit of financial information and another. Consider the ratio of current assets to current liabilities, which we refer to as the current ratio. This ratio is a comparison between assets that can be readily turned into cash—current assets—and the obligations that are due in the near future—current liabilities. A current ratio of 2 or 2:1 means that we have twice as much in current assets as we need to satisfy obligations due in the near future.

FINANCIAL STATEMENT ANALYSIS

Ratios can be classified according to the way they are constructed and the financial characteristic they are describing. For example, we will see that the current ratio is constructed as a coverage ratio (the ratio of current assets—available funds—to current liabilities—the obligation) that we use to describe a firm’s liquidity (its ability to meet its immedi- ate needs).

There are as many different financial ratios as there are possible combinations of items appearing on the income statement, balance sheet, and statement of cash flows. We can classify ratios according to how they are constructed or according to the financial characteristic that they capture.

Ratios can be constructed in the following four ways:

1. As a coverage ratio. A coverage ratio is a measure of a firm’s ability to “cover,” or meet, a particular financial obligation. The denominator may be any obligation, such as interest or rent, and the numerator is the amount of the funds available to satisfy that obligation.

2. As a return ratio. A return ratio indicates a net benefit received from a particular investment of resources. The net benefit is what is left over after expenses, such as operating earnings or net income, and the resources may be total assets, fixed assets, inventory, or any other investment.

3. As a turnover ratio. A turnover ratio is a measure of how much a firm gets out of its assets. This ratio compares the gross benefit from an activity or investment with the resources employed in it.

4. As a component percentage. A component percentage is the ratio of one amount in a financial statement, such as sales, to the total of amounts in that financial statement, such as net profit.

In addition, we can also express financial data in terms of time— say, how many days’ worth of inventory we have on hand—or on a per share basis—say, how much a firm has earned for each share of common stock. Both are measures we can use to evaluate operating performance or financial condition.

When we assess a firm’s operating performance, we want to know if it is applying its assets in an efficient and profitable manner. When we assess a firm’s financial condition, we want to know if it is able to meet its financial obligations. We can use financial ratios to evaluate five aspects of operating performance and financial condition:

1. Return on investment

2. Liquidity

3. Profitability

Financial Ratio Analysis

4. Activity

5. Financial leverage There are several ratios reflecting each of the five aspects of a firm’s

operating performance and financial condition. We apply these ratios to the Fictitious Corporation, whose balance sheets, income statements, and statement of cash flows were discussed in Chapter 6 and were pre- sented in Exhibits 6.1, 6.4, and 6.6 of that chapter. The ratios we intro- duce now are by no means the only ones that can be formed using financial data, though they are some of the more commonly used. After becoming comfortable with the tools of financial analysis, you will be able to create ratios that serve your particular evaluation objective.