Financial ratio analysis

The analysis of the performance and financial condition of a company is carried out by computing several ratios fi om information given in its annual report. Such analysis must be done carefully because seemingly good performance might be due more to such factors as inflation and reduction of inventory than to improvements in company operations. 

The current ratio is defined as current assets divided by current liabilities. It is an indication of the ability of a company to meet short-term debt obligations. The higher the current ratio, the more liquid the company is. However, too high a ratio may indicate that the company is not putting its cash or equivalent cash to good use. A reasonable ratio is two, but it is better to compare current ratios of companies in a similar business. From Table 16.3, the current assets ratio of U.S. Chemicals is 4,630/4,153 = 1.11, which is alow value. At the end of the year 2000, Monsanto Company had a much better current ratio of 1.80. 

The acid-test ratio, also called the quick ratio, is a modification of the current ratio with the aim of obtaining a better measure of the liquidity of a company. In place of current assets, only assets readily convertible to cash, called quick assets, are used. Thus, it is defined as the ratio of current assets minus inventory to current liabilities. Marketable securities, accounts receivable, and deferred income tax assets are considered to be part of quick assets. From Table 16.3, the quick assets for U.S. Chemicals, in millions of dollars, is 4,630 - 1,420 -312 = 2,898. This gives an acid-test ratio of 2,898/4,153 = 0.70, which is not a desirable ratio, since it is less than one. At the end of the year 2000, Monsanto Company had a much better acid-test ratio of 1.35. 

The equity ratio is defined as the ratio of stockholders equity to total assets. It measures the long-term financial strength of a company. From Table 16.3, the equity ratio for U.S. Chemicals is 4,361/14,211 = 0.31, which, again, is too low a value. This ratio should be about 0.50. If the equity ratio is too high, the company may be curtailing its growth. At the end of the year 2000, Monsanto Company had an equity ratio of 0.63. 

The above three financial ratios use only data from the balance sheet. We next consider two ratios that use both the balance sheet and the income statement, followed by two ratios that use data from the income statement only. These ratios are particularly susceptible to economic conditions, which can, sometimes, change quickly from year to year. In the United States, the year 2000 started with economic prosperity, but a downturn occurred in early 2001, leading to a recession that continued to the end of that year. 

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Financial ratio analysis is only as valid as the financial information on which it is based. If the information provided in the financial statements hasn t been independendy verified (audited), the results of a financial ratio analysis are not likely to give the reader an accurate assessment of the financial performance of that organization. While financial ratio analysis can provide valuable insight to the performance of any organization, it is important that the users of financial ratios are also mindful of their limitations ... 

Be able to assess the financial condition of a company by applying financial ratio analysis to data given in its aimual report. 

The next chapter vwll discuss financial ratio analysis. To truly understand what ratios imply, it is necessary to know what components comprise the ratios and how they are calculated. Additionally,... 

In financial matters, a similar technique, ratio analysis, is used to judge whether a company is healthy witli respect to industry standards. In ratio analysis most of die quantities compared are quantities of money, so the ratio of one quantity of money to another quantity of money is, by definition, a new dimensionless ratio (like die Reynolds number or lift coefficient), and these financial ratios can be used to compare businesses in similar industries or businesses (in engineering, such comparison is referred to as dynamic similitude). 

The chapter considered the engineer s fear of financials and attempted to overcome it with a straightforward discussion of cash flow, income, and balance statements. The mathematics of these statements is simple arithmetic, but the confusion seems to come from not understanding a few key terms. The chapter also considered the utility of ratio analysis—what engineers might call dimensional analysis for companies—breakeven analysis, and the basics of the time value of money. Although a full discussion was beyond the scope of this chapter, the discussion served up the basics and may also serve to introduce more careful treatments in other courses or texts. 

To evaluate accounting information, business people evaluate financial statements in three broad areas (1) horizontal analysis, (2) vertical analysis, and (3) ratio analysis. 

In addition to using financial statements for comparative horizontal and vertical analysis, ratios are another available tool. Developing relationships among financial statement items is the crux of ratio analysis. In this type of analysis, it is extremely important for the evaluators, such as creditors or management, to select the ratio applicable to their immediate area of concern. Then, the relevant ratio can be calculated for analysis, and, finally, more research might be necessary as ratio analysis is limited. 

In addition to financial sfafemenf analysis, e.g., horizonfal analysis, the rate-of-debt-to-total-assets raho and the hmes-interest-earned ratio can be used to evaluate the capital structure and strategic financial strengths and weaknesses of an enterprise. 

Accounting sfatemenfs and tools such as ratio analysis increase the supply of currenf financial information and facilitate more effective business decisions, as decision making often occurs in an uncertain and constantly changing environment. 

Chapter 3 was completely revised to reflect current practice with respect to accounting and financial reporting. The accounting example for Delchem Corporation was shortened, and financial reporting and financial analysis were augmented and updated. Financial ratios were presented and applied to Archem operations. Finally, a Z-score indicator that determines the potential for bankruptcy was introduced and also applied to Archem. Excerpts from Monsanto s 1994 annual report were included to illustrate a real-world annual report. 

This analysis is targeted at separating corporations of good and poor credit quality on the basis of a set of data (e.g. financial ratios). A discriminant function can, for example, be formulated as follows ... 

In order to establish this function, a logical preselection of appropriate data is carried out safeguarding a sufficient representation of the net worth, financial position, and results of the corporation. Here, it should be kept in mind that the financial ratios selected have to show only moderate correlations in order to avoid multicorrelation problems known from regression analysis. With the help of multiple discriminant... 

Edward I. Altman, Financial Ratios, Discriminant Analysis and the Prediction of Corporate Bankruptcy, Journal of Finance 23, no. 4 (September 1968), pp. 589-609. 

On the basis of the selected appropriate financial ratios that show significantly different group means for industrial corporations of good and poor credit quality and are additionally fundamentally clear indicators, a quantitative rating model is developed with the help of discriminant analysis. 

The non-financial element of a company credit analysis has assumed a more important role in recent years, especially with regard to companies in exotic or emerging markets. Credit analysts review the non-financial factors relevant to the specific company after they have completed the financial and ratio analysis. These include the strength and competence of senior management and the degree of exposure to overseas markets. The depth of overseas exposure is not always apparent from documents such as the annual report, and analysts sometimes need to conduct further research to determine this. Companies with considerable overseas exposure, such as petroleum companies, also need to be reviewed with respect to the political situation in their operating locations. A bank such as... 

Understanding ratio analysis is foundational to making sense of financial and operations ratios. An organization s successes and areas in need of attention from management are highlighted by performance ratio analysis. Ratios are used to evaluate the performance of an organization, an industry, and management personnel. 

Financial statements were explained in detail in Chapter 3, providing a foundation to understand ratio analysis. This chapter will introduce many of the common financial performance ratios that executives and analysts use. In addition, the chapter will explain how to compute ratios, what information the ratios offer for decision making, and how to consider multiple factors that are critical to fully understanding the ratios. In subsequent chapters, how operations and supply chain ratios affect and influence financial ratios will be examined. Operations ratios, after all, are used to ensure that financial performance meets the e q)ectations of creditors, investors, and executives. Ultimately, these ratios provide information about an organization s financial health and ability to continue operations. 

Before financial ratios are discussed in detail, a general introduction to ratio analysis is provided first. How might ratio be defined anyway A ratio is a relationship or comparison between two numbers. It is a statement of how two numbers compare to each other. It compares the size of one number with the size of another number. It is the quantitative relation between two amounts showing the number of times one value is contained within the other. 

Chapter 4 Ratio Analysis with Financial Statements... 

Capital Investment. Erom the viewpoint of a project, all of the capital that must be raised is external capital. Equity capital is the ownership capital, eg, common and preferred stocks or retained cash, whereas debt capital consists of bonds, mortgages, debentures, and loans. Nearly all investment involves a mixture of both types so as to maximize the return on investment (21). The debt ratio (debt/total capital) for the chemical industry is typically over 30%. Because financial details are not well known during the preliminary phases of project analysis, the investment is viewed simply as the total capital that must be expended to design and build the project. 

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