Teaching Note 4

Financial Ratio Analysis

Common Financial Ratios:
An Illustration using the Pharmaceutical Industry, 1981

Profitability Ratios:

Return On Assets. The ROA measure of profitability is not affected by the company's capital structure. The ratio measures the amount of plant and equipment, and other assets employed to generate profits. This ratio needs to be examined along with the ROI, or return on shareholder's equity.

Return On Shareholder's Equity (ROE). Return on equity or ownership capital is the most significant profitability measure to investors. To the investor the measure reports returns on dollar invested to permit comparisons across firms. To management the ratio is important because it can be dissected to reveal sources of financial performance

If this ratio is higher than the industry average, this may indicate poor management of working capital. Why? If the ratio is too low, this may not be "bad" if the current assets are very liquid (cash or securities).

Operating versus Non-Operating Contributions to ROE:

The operating factors relate to areas in which business can intervene (increase prices or reduce expenses, or improve use of assets). The non-operating factors are not controlled by management (tax rates and stock-holder investment). Since debt is not included in ROI, and since debt affects the amount of assets, a highly leverage firm can have a high ROI.

Sales Margin (or Profit Margin). This measures the percentage of each sales dollar that gets to the "bottom line" as profit. High is better than low.

Return to Investors. This is a measure introduced by Fortune magazine to remedy measurement problems with ROA, ROE, and Profit Margin. ROA is a problem measure because it depends upon the age of assets booked. If assets are old and were acquired at a low price, the balance sheet probably understates their value. Thus, ROA overstates performance. ROE is similarly a problem as equity is booked on the balance sheet at historical value, not the current stock market price. The Return to Investors ratio includes the stock market price increase and the stock dividend yield for a stock held for one year. This ratio has not yet gained widespread use.

Working Capital Ratios:

These are indicators of the efficiency of working capital and asset management. Each activity ratio examines the relationship between annual sales and some asset item that it related to production of the sale.

Total Asset Turnover: This measures how asset intensive a firm is and how efficiently assets are employed.

Avg. Collection Period: Because most sales are made on the basis of credit, to assess how well a firm is managing its accounts receivable - collecting on credit sales - this ratio rreports how long bills are not being collected.

When the collection period is long, the company does not have access to the cash that the sale was supposed to generate. Also, long overdue accounts receivable may indicate "bad debts" - non-collectable accounts.

Inventory Turnover: Inventory has to move. The company makes products to sell, not sit in the warehouse. Normally, a high turnover is desired. Different ways to evaluate inventory (FIFO and LIFO) can mislead cross-company comparisons.

Growth Performance Measures:

Trends and Analysis of Financial Ratios:

As is demonstrated in these examples, firms differ; and, these differences change over time. The analyst needs to examine the movement of ratios across time. If the relative position of firms on key indicators remains pretty much constant across time, we can assume that consistent fluctuations signal normal movements of the business cycle. When a firm deviates from its, more or less, "normal" relative position on an indicator, this is a "flag" that indicates a need for further investigation. Deviations from routine can signal non-interesting changes such as accounting adjustments or chance movements of the data, or significant strategic changes.

The graphic below demonstrates Squibb's deteriorating performance since 1977. Squibb's position back in 1977 was at, or near, the group norm. By examining ROA and ROE in the time periods since 1977 the demise of Squibb as an autonomous firm is sharply demonstrated.