Financial Ratios - A Tool for Meaningful Comparisons

As of 31st May 2021, Nike, Inc. reported current assets of $26,291 million and current liabilities of $9,674 million. We can find the relationship between these two metrics by dividing current assets by current liabilities. The alternative ways of stating the relationship are as follows:

  • Current assets are 2.72 times current liabilities; or
  • Current assets are 272% of current liabilities.  

What we are doing here is calculating ratios. The dollar value of 26,291 is 2.72 times the dollar value of 9,674 and we know from elementary arithmetic that 2.72 is the same 272 percent. In simple words, a ratio states a quantity relative to another quantity. The relationship is stated in terms of either a percentage, a rate, or a simple proportion. Interestingly, ratios can reveal underlying conditions that may not be apparent from individual financial statement components. However, a single ratio by itself may not be very meaningful. Thus, we generally use ratios for the following types of comparisons.

  1. Intra-company comparisons: Comparisons within a company are often useful to detect changes in financial relationships and significant trends. For example, a comparison of Nike’s current year’s profit margin with that of the prior year reveals whether profitability has improved or deteriorated. 
  2. Inter-company comparisons: Comparisons with competitors provide insight into a company’s competitive position. For example, investors can compare Nikes’s current year’s profitability with that of one of the competitors in the shoe segment, such as Adidas.
  3. Industry average comparisons: Comparisons with industry averages furnish information about a company’s relative position within the industry. For example, potential investors can compare Nike’s financial data with the averages for its industry compiled by financial rating organizations such as Dun & Bradstreet, Moody’s, and Standard & Poor’s, or with the information provided on the Internet by organizations such as Yahoo! on its financial site.

Now that we have understood what a ratio is, and how it can be used for different types of comparisons, let’s now talk about ratio analysis. Ratio analysis, in simple terms, brings out the relationship among selected items of financial statement data. To analyze the primary financial statements, we generally use ratios to evaluate liquidity, solvency, and profitability. 

Let’s first talk about the liquidity ratios. Liquidity ratios measure the short-term ability of the company to pay its maturing obligations and to meet unexpected cash needs. Short-term creditors such as bankers and suppliers are particularly interested in evaluating liquidity. Some of the commonly used liquidity ratios are presented below:

Screenshot 2022-02-17 at 7.07.17 PM

Let’s now talk about solvency ratios. Solvency ratios measure the ability of the company to survive over a long time. Long-term creditors show a keen interest in a company’s long-run solvency, particularly its ability to pay interest as it comes due and to repay the balance of debt at its maturity. Some of the commonly used solvency ratios are presented below:

Screenshot 2022-02-17 at 7.04.32 PM

Now, let’s discuss profitability ratios. Profitability ratios measure the income or operating success of a company over some time. A company’s profit, or dearth of it, impacts its ability to obtain debt and equity financing, its liquidity position, and its ability to expand. As a consequence, creditors and investors alike are interested in evaluating profitability. Profitability is often used as the ultimate test of management’s operating efficacy. Some of the commonly used profitability ratios are presented below:

Screenshot 2022-02-17 at 7.05.34 PM

In addition to liquidity ratios, solvency ratios, and profitability ratios, we might need to compute some ratios relating to market valuation. Market value ratios are used to evaluate the share price of a company’s stock. Commonly used market value ratios are price-earnings ratio (i.e., market price per share/earnings per share), price to book ratio (i.e., market price per share/book value per share), and dividend yield (i.e., dividend per share/market price per share). 

To sum up, financial ratios serve two main purposes—tracking company performance and making comparative judgments regarding company performance. However, financial ratios are not free from limitations. As they are computed based on the financial statements, they suffer from the same limitations as the financial statements do, namely, historical orientation, subjectivity from the choice approach to accounting, and inability to factor in the effect of inflation and time value of money.

 

Topics: ACCA, CIMA, CPD, AAT, FRM