12.1: Introduction to Ratio Analysis

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Page ID: 97801

Henry Dauderis and David Annand
Athabasca University via Lyryx Learning

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Learning Objectives

LO1 – Describe ratio analysis, and explain how the liquidity, profitability, leverage, and market ratios are used to analyze and compare financial statements.

A common way to evaluate financial statements is through ratio analysis. A ratio is a relationship between two numbers of the same kind. For example, if there are two apples and three oranges, the ratio of the number of apples to the number of oranges is 2:3 (read as "two to three"). A financial ratio is a measure of the relative magnitude of two selected numerical values taken from a company's financial statements. For instance, the gross profit percentage studied in Chapter 6, also known as the gross profit ratio, expresses the numerical relationship between gross profit and sales. If a company has a gross profit ratio of 0.25:1, this means that for every $1 of sales, the company earns, on average, $0.25 to cover expenses other than cost of goods sold. Another way of stating this is to say that the gross profit ratio is 25%.1

Financial ratios are effective tools for measuring the financial performance of a company because they provide a common basis for evaluation — for instance, the amount of gross profit generated by each dollar of sales for different companies. Numbers that appear on financial statements need to be evaluated in context. It is their relationship to other numbers and the relative changes of these numbers that provide some insight into the financial health of a business. One of the main purposes of ratio analysis is to highlight areas that require further analysis and investigation. Ratio analysis alone will not provide a definitive financial evaluation. It is used as one analytic tool, which, when combined with informed judgment, offers insight into the financial performance of a business.

For example, one business may have a completely different product mix than another company even though both operate in the same broad industry. To determine how well one company is doing relative to others, or to identify whether key indicators are changing, ratios are often compared to industry averages. To determine trends in one company's performance, ratios are often compared to past years' ratios of the same company.

To perform a comprehensive analysis, qualitative information about the company as well as ratios should be considered. For example, although a business may have sold hundreds of refrigerators last year and all of the key financial indicators suggest growth, qualitative information from trade publications and consumer reports may indicate that the trend will be towards refrigerators using significantly different technologies in the next few years. If the company does not have the capacity or necessary equipment to produce these new appliances, the present positive financial indicators may not accurately reflect the likely future financial performance of the company.

An examination of qualitative factors provides valuable insights and contributes to the comprehensive analysis of a company. An important source of qualitative information is also found in the notes to the financial statements, which are an integral part of the company's financial statements.

In this chapter, financial ratios will be used to provide insights into the financial performance of Big Dog Carworks Corp. (BDCC). The ratios will focus on financial information contained within the income statement, statement of changes in equity, and balance sheet of BDCC for the three years 2019, 2020, and 2021. This information is shown below. Note that figures in these statements are reported in thousands of dollars (000s). For consistency, all final calculations in this chapter are rounded to two decimal places.

Big Dog Carworks Corp.
Balance Sheet
At December 31
($000s)
Assets
	2021		2020		2019
Current
Cash	$	20	$	30	$	50
Short-term Investments		36		31		37
Accounts Receivable		544		420		257
Inventories		833		503		361
		1,433		984		705
Property, Plant, and Equipment, net		1,053		1,128		712
Total Assets	$	2,486	$	2,112	$	1,417
Liabilities
Current
Borrowings	$	825	$	570	$	100
Accounts Payable		382		295	$	219
Income Taxes Payable		48		52	$	50
		1,255		917		369
Equity
Share Capital		1,063		1,063		963
Retained Earnings		168		132		85
		1,231		1,195		1,048
Total Liabilities and Equity	$	2,486	$	2,112	$	1,417

Big Dog Carworks Corp.
Income Statement
For the Year Ended December 31
($000s)
	2021		2020		2019
Sales (net)	$	3,200	$	2,800	$	2,340
Cost of Goods Sold		2,500		2,150		1,800
Gross Profit		700		650		540
Operating Expenses
Selling, General, and Administration		212		183		154
Employee Benefits		113		109		119
Depreciation		75		84		63
		400		376		336
Income from Operations		300		274		204
Financing Costs
Interest		89		61		-0-
Income Before Income Taxes		211		213		204
Income Taxes		95		96		92
Net Income	$	116	$	117	$	112

Big Dog Carworks Corp.
Statement of Changes in Equity
For the Year Ended December 31
($000s)
	2021			2020	2019
	Share Capital	Retained Earnings	Total Equity	Total Equity	Total Equity
Opening Balance	$1,063	$132	$1,195	$1,048	$ 43
Common Shares Issued				100	953
Net Income		116	116	117	112
Dividends Declared		(80)	(80)	(70)	(60)
Ending Balance	$1,063	$168	$1,231	$1,195	$1,048

Assume that 100,000 common shares are outstanding at the end of 2019, 2020, and 2021. Shares were issued in 2020, but at the end of year the number of outstanding shares was still 100,000.

There are four major types of financial ratios: a) liquidity ratios that measure the ability of a corporation to satisfy demands for cash as they arise in the near-term (such as payment of current liabilities); b) profitability ratios that measure various levels of return on sales, total assets employed, and shareholder investment; c) leverage ratios that measure the financial structure of a corporation, its amount of relative debt, and its ability to cover interest expense; and d) market ratios that measure financial returns to shareholders, and perceptions of the stock market about the corporation's value.

Initial insights into the financial performance of BDCC can be derived from an analysis of relative amounts of current and non-current debt. This analysis is addressed in the following sections.