Financial Ratios

Numerous financial ratios are used in the financial analysis of a firm. Here we shall introduce six commonly used ratios to illustrate their use in a comparison with ratios from the industry-total data and in trend analysis. To facilitate the discussion, we shall use Tables 6.6 and 6.7, which show the balance sheets and income statements for Electco Electronics, a small electronics equipment manufacturer.

The first two financial ratios we address are referred to as Hquidity ratios. Liquidity-ratios evaluate the ability of a business to meet its current liability obligations. In other words, they help us evaluate its ability7 to weather unforeseen fluctuations in cash flows. A company that does not have a resene of cash, or other assets that can be converted into cash easily, may not be able to fulfill its short-term obligations.

A company's net resen-e of cash and assets easily converted to cash is called its working capital. Working capital is simply7 the difference between total current assets and total current liabilities:

Working capital = Current assets - Current liabilities

Table 6.4 Example of Industry-Total Balance Sheet (in Millions of $)

Electronic Product Manufacturing Balance Sheet

Assets

Assets

Cash and deposits

S 2 547

Accounts receivable and accrued revenue

9 169

Inventories

4 344

Investments and accounts with affiliates

10 066

Portfolio investments

1 299

Loans

839

Capital assets, net

4 966

Other assets

2 898

Total assets

S36 128

Liabilities and Owners' Equity

Liabilities

Accounts payable and accrued liabilities

$ 8 487

Loans and accounts with affiliates

3 645

Borrowings:

Loans and overdrafts from banks

1 408

Loans and overdrafts from others

1 345

Bankers' acceptances and paper

232

Bonds and debentures

2 487

Mortgages

137

Deferred income tax

(247)

Other liabilities

1 931

Total liabilities

S19 426

Owners' Equity

Share capital

9 177

Contributed surplus and other

415

Retained earnings

7 110

Total owners' equity

S16 702

Current assets

S17 663

Current liabilities

11 692

The adequacy of working capital is commonly measured with two ratios. The first, the current ratio, is the ratio of all current assets relative to all current liabilities. The current ratio may also be referred to as the working capital ratio.

_ . Current assets

Current ratio

Current liabilities

Electco Electronics had a current ratio of 4314/2489 = 1.73 in 2008 (Table 6.6). Ordinarily, a current ratio of 2 is considered adequate, although this determination may depend a great deal on the composition of current assets. It also may depend on industry standards. In the case of Electco, the industry standard is 1.51, which is listed in Table 6.8. It would appear that Electco had a reasonable amount of liquidity in 2008 from the industry's perspective.

Table 6.5 Example of Industry-Total Income Statement (Millions of $)

Electronic Product Manufacturing Income Statement

Operating revenues

$50 681

Sales of goods and services

49 357

Other operating revenues

1324

Operating expenses

48 091

Depreciation, depletion,

and amortization

1501

Other operating expenses

46 590

Operating profit

2590

Other revenue

309

Interest and dividends

309

Other expenses

646

Interest on short-term debt

168

Interest on long-term debt

478

Gains (Losses)

(122)

On sale of assets

25

Others

(148)

Profit before income tax

2130

Income tax

715

Equity- in affiliates' earnings

123

Profit before extraordinary gains

1538

Extraordinary gains/losses

—

Net profit

1538

A second ratio, the acid-test ratio, is more conservative than the current ratio. The acid-test ratio (also known as the quick ratio) is the ratio of quick assets to current liabilities:

Quick assets

Current liabilities

The acid-test ratio recognizes that some current assets, for example, inventory and prepaid expenses, may be more difficult to turn into cash than others. Quick assets are cash, accounts receivable, notes receivable, and temporary investments in marketable securities— those current assets considered to be highly liquid.

The acid-test ratio for Electco for 2008 was (431 + 2489)/2489 = 1.17. Normally, an acid-test ratio of 1 is considered adequate, as this indicates that a firm could meet all its current liabilities with the use of its quick current assets if it were necessary. Electco appears to meet this requirement.

The current ratio and the acid-test ratio provide important information about how liquid a firm is, or how well it is able to meet its current financial obligations. The extent to which a firm relies on debt for its operations can be captured by what are called leverage or debt-management ratios. An example of such a ratio is the equity ratio. It is the ratio of total owners' equity to total assets. The smaller this ratio, the more dependent the firm is on debt for its operations and the higher are the risks the company faces.

Table 6.6 Balance Sheets for Electco Electronics for Years Ended 2008, 2009, and 2010

Electco Electronics

Year-End Balance Sheets

(in thousands of dollars)

2008

2009

2010

Assets

Current assets

Cash

431

340

320

Accounts receivable

2489

2723

2756

Inventories

1244

2034

2965

Prepaid services

150

145

149

Total current assets

4314

5242

6190

Long-term assets

Buildings and equipment

(net of depreciation)

3461

2907

2464

Land

521

521

521

Total long-term assets

3982

3428

2985

Total Assets

8296

8670

9175

Liabilities

Current liabilities

Accounts payable

1493

1780

2245

Bank overdraft

971

984

992

Accrued taxes

25

27

27

Total current liabilities

2489

2791

3264

Long-term liabilities

Mortgage

2489

2455

2417

Total Liabilities

4978

5246

5681

Owners' Equity

Share capital

1825

1825

1825

Retained earnings

1493

1599

1669

Total Owners' Equity

3318

3424

3494

Total Liabilities and Owners' Equity

8296

8670

9175

Total owners' equity Total liabilities 4- Total equity

Total owners' equity Total assets

The equity ratio for Electco in 2008 was 3318/8296 = 0.40 and for the industry was 0.46 as shown in Table 6.8. Electco has paid for roughly 60% of its assets with debt; the remaining 40% represents equity. This is close to the industry practice as a whole and would appear acceptable.

Table 6.7 Income Statements for Electco Electronics for Years Ended 2008, 2009, 2010

Electco Electronics

Income Statements

(in thousands

of dollars)

2008

2009

2010

Revenues

Sales

12 440

11 934

12 100

Total Revenues

12 440

11 934

12 100

Expenses

Cost of goods sold

(excluding depreciation)

10 100

10 879

11 200

Depreciation

692

554

443

Interest paid

346

344

341

Total Expenses

11 138

11 777

11 984

Profit before taxes

1302

157

116

Taxes (at 40%)

521

63

46

Profit before extraordinary items

781

94

70

Extraordinary gains/losses

70

Profit after taxes

851

94

70

Table 6.8 Industry-Standard Ratios and Financial Ratios for Electco Electronics

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