Ratio Analysis

All items in the financial statements of a business enterprise are, in some way linked to the chief economic activity of that business, such as sales of products, billings for service rendered, rent on real estate, and so on. For example, there is a relationship between the amount of sales a business achieves and the amount of credit it provides its customers to make those sales. In like manner, there is a relationship between sales activity and the bottom line, or the net profit of a business. More importantly, standards of performance by type and size of business have evolved over the years, and key ratios have been developed to help managers and analysts identify and correct business problems.

The principle of ratio analysis is that businesses by size and category in competition with each other have developed competitive standards that enable them to survive in the marketplace. These standards include such items as the amount of assets necessary to produce a level of sales, the amount of debt to carry, and profit levels acceptable to the investment community for that industry.

These ratio standards are widely known and disseminated, and the Federal Government also codifies the basic standards, by industry, in what is known as Standard Industry Coding.

While there may be as many as one hundred ratios used by industry, there are about fifteen basic, or widely accepted, ratios falling into four major categories: measures of survivability, measures of productivity and efficiency, measures of skill in the use of borrowed funds, and profitability and investment criteria.

The survivability quotient of a business is a function of it ability to pay its debts in the ordinary course of business. This ratio, called current or working capital ratio, measures this capability by dividing its current assets by its current liabilities, and then comparing it to industry averages. A ratio substantially below comparable businesses may be a warning signal to the management or to a credit analyst about the debt burden or the cash flows of that business.

Similar operating ratios are used that measure the amount of inventory carried, the bill paying policy, and the amount of assets being financed by a business as a function of its sales relative to competitors. Additionally, many reasons exist why a company should use borrowed dollars for financing instead of reinvesting earnings or selling stock. Competitive financing is measured by what are called "leverage ratios" that include such comparisons as the amount of operating profit available to pay interest cost and the total amount of borrowed dollars financing the assets of the business.

On the bottom line, a company must be comparably profitable if it is to attract stock and bond investors at competitively low rates of capital. As such, its profitability quotients need to be tested against the industry in such categories as pricing, manufacturing cost, operating and financial expenses, the use of borrowed funds and, ultimately, its return to the equity owners of the business.

This is the essential work of ratio analysis.

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