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Suppose that you heard that both XYZ grocery and Google each made a million dollars last year. What would your reaction be?

Probably that the grocery store did well and that Google had a bad year. Why? Because the two are vastly different sizes. For this reason we need to some how make adjustment to be able to compare across firms.

Common sized financial statements

These adjustments are actually very easy to do. All we have to do is to scale the numbers by something.

Common-sized balance sheets–everything is listed as a percentage of total assets. Here the two sides of the balance sheet each sum to 100%.

Common-sized income statements–Everything is listed as a percentage of sales.(hence it is also known as (AKA) as the the percentage of sales method).

Financial Ratios

Ratios are based on the same basic idea as standardized financial statements: that is we are going to scale the various accounting numbers by something. In fact it can be argued that standardized financial statements are nothing more than ratios.

Ratios are useful in that they summarize much data and put it in a usable format that can be compared across different firms and also the same firm over different times.

Firms and investors both use ratios to quickly look over the vast array of data that is available. One problem is that different firms calculate ratios in different ways. This makes it hard to compare ratios at different firms without first making sure the ratios are calculated in a similar way. Moreover, it makes it very difficult to make comparisons internationally where the actual financial statements may differ greatly.

How are ratios used? They can be used as an early warning system, as a means of monitoring management, and as a screening tool. Ratios are used by both firms and investors. As such they are useful when comparing other firms within the industry or the same firm at different points of time. For industry comparisons http://Finance.yahoo.com is excellent. Merely type in a ticker symbol, go to profile, and then ratio comparison.

Generally ratios are broken into four or 5 categories. Each book and firm will call the categories something slightly different but the idea of the categories is the same.

1. Short-term solvency (or liquidity) ratios

Current ratio = Current Assets/Current Liabilities
Quick ratio = (Current assets – Inventory) / Current liabilities
the Quick ratio is also called the acid test
Cash ratio = Cash / Current Liabilities

These all measure how well the firm can meet short-term obligations. Higher is better, but again too high suggests waste and can lead to a lack of discipline.

Want to jump ahead again? this lack of discipline that results of having too much financial flexibility is called the Free Cash flow problem (Jensen 1986). At first glance this maybe counter-intuitive: it is a problem of too much cash. This is a problem since managers may waste it.

2. Long-term solvency (or financial leverage or capital structure) ratios

Total debt ratio = (Total Assets – Total Equity) / Total Assets
Debt to equity = Total DEbt / Total Equity
Equity Multiplier = Total Assets / Total Equity
= 1 + Debt to equity ratio
Times interest Earned = TIE
= EBIT / Interest
Fixed charges coverage = EBIT / (Interest expense + lease payments)
Cash coverage = (EBIT + Depreciation) / Interest

3. Asset management (AKA turnover or efficiency ratios)

Inventory Turnover = COGS/Inventory
(some firms use sales / inventory, but COGS is more accurate)
Days Sales in inventory = 365 days / Inventory

Receiveables Turnover = Credit sales / (accounts receivable)
Days sales in receivables = 365 / (Receivables turnover)

Total Asset Turnover = Sales / Total Assets

4. Profitability ratios

Profit margin = Net Income / Sales
Return on Assets = Net Income / Total Assets
Return on Equity = Net Income / Total Equity

5. Market Value Measures

EPS = Net Income / Shares Outstanding
PE ratio = Market Price per share / Earnings per share
Market to book value = Market value per share / Book value per share
Tobin’s Q = Market value / Replacement Value

Dupont Identity

This shows the relationship between the various ratios.

ROE = (NI / Total Equity) if you want you can multiply by assets/assets
= NI / Assets * Assets / Total Equity
= ROA * equity multiplier

Now multiply each by sales/sales

= (net income / sales) * (sales/assets) * (assets/ total Equity)
= profit margin * total asset turnover * equity multiplier

This shows that ROE is affected by profit margins, asset use efficiency, and financial leverage.


Ratios are like an odometer.  They tell you some things but not everything.

If you are driving 55 miles per hour is that fast or slow? Don’t know? Why not?


Internal and sustainable growth

Dividend payout ratio = Cash dividends / net income

Retention ratio = addition to retained earnings / net income
= plowback ratio
= (1 – payout ratio)

Sustainable growth rate = ROE * plowback

or more accurately:

g = ROA * plowback / (1-ROA*plowback)

Ratios and the percentage of sales methods will be used again when we make cash flow projections. These projections are out “crystal ball” where we try to determine how much a firm or project is worth. This is done largely by making assumptions about ratios and the percentages of sales we expect in the future.

Quick Quiz:
1. Why are ratios used?

2. How are ratios useful when used across the industry?

3. How can ratios be used for monitoring management?

4. What is a difficulty in using ratios for firms in different countries?

5. Why are ratios like odometers?

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