Ratio Analysis

Introduction to Ratio Analysis of Financial Information

Although reviewing trends and using common-size analysis provides an excellent starting point for analyzing financial information, managers, investors, and other stakeholders also find it valuable to use various ratios to assess the financial performance and financial condition of organizations.

Ratio analysis consists of calculating various ratios from an organization’s financial data (financial statements, Annual Report, etc.) and analyzing what these ratios reveal about how an organization is doing and how they compare to other businesses in the same industry.

Ratios can reveal valuable information about how a business is presently performing, its past performance, and its potential future performance. Ratio analysis can also help investors and entrepreneurs make decisions about start-up businesses, by examining the ratios of similar businesses. These analyses can help management predict how well their organization might expect to do in the first few years of operation and help investors decide whether or not it will be worthwhile to invest in the organization.

Ratio analysis can answer questions like:

How is this company doing this year compared to last year?
How is an organization doing compared to its competitors?
What is the level of efficiency in this company?
How would you describe the overall health of this company?
Is this company facing any financial difficulties? If yes, what kinds?
What can we expect from this company in the future?

Categories of Ratios Used to Evaluate An Organization’s Financial Health

The four categories of ratios presented in this section are as follows:

Ratios used to measure profitability (focus is on the income statement).
Ratios used to measure short-term liquidity (focus is on short-term liabilities).
Ratios used to measure long-term solvency (focus is on long-term liabilities).
Ratios used to measure market valuation (focus is on market value of the company).

For each ratio, we (1) explain the meaning, (2) provide the formula, (3) calculate the ratio for Coca-Cola for two years, and (4) compare the ratio for Coca-Cola to PepsiCo’s ratio and industry averages. (Note: All industry averages throughout this competency were obtained from MSN Money. (This content will be opened in a separate window or downloaded to your computer) Some averages are not available or not applicable and will be noted as such.)

The tables below summarize the formulas for all the ratios presented in this section, and show the ratio results for Coca-Cola, PepsiCo, and the industry averages that will be covered throughout this section.

Table 2.3 Financial Ratio Formulas
Profitability Measures
1.	Indicates the gross margin generated for each dollar in net sales.
2.	Indicates the profit generated for each dollar in net sales.
3.	Indicates how much net income was generated from each dollar in average assets invested.
4.	Indicates how much net income was generated from each dollar of common shareholders’ equity.
5.	Indicates how much net income was earned for each share of common stock outstanding.
Short-Term Liquidity Measures
6.	Indicates whether a company has sufficient current assets to cover current liabilities.
7.	Indicates whether a company has sufficient quick assets to cover current liabilities.
8.	Indicates how many times receivables are collected in a given period.
9.	Indicates how many days it takes on average to collect on credit sales.
10.	Indicates how many times inventory is sold and restocked in a given period.
11.	Indicates how many days it takes on average to sell the company’s inventory.
Long-Term Solvency Measures
12.	Indicates the percentage of assets funded by creditors.
13.	Indicates the amount of debt incurred for each dollar that owners provide.
14.	Indicates the company’s ability to cover its interest expense related to long-term debt with current period earnings.
Market Valuation Measures
15.	Indicates the value of a company at a point in time.
16.	Indicates the premium investors are willing to pay for shares of stock relative to the company’s earnings.

Table 2.4 Summary of Financial Ratios for Coca-Cola, PepsiCo, and the Industry Average
		Coca-Cola 2010	PepsiCo 2010	Industry Average 2010
Profitability Measures
1.	Gross margin ratio	63.9 percent	54.1 percent	56.1 percent
2.	Profit margin ratio	33.6 percent	10.9 percent	19.2 percent
3.	Return on assets	19.4 percent	11.7 percent	14.2 percent
4.	Return on common shareholders’ equity	41.7 percent	32.3 percent	34.7 percent
5.	Earnings per share	$5.12	$3.97	Not applicable
Short-Term Liquidity Measure
6.	Current ratio	1.17 to 1	1.11 to 1	1.20 to 1
7.	Quick ratio	0.85 to 1	0.80 to 1	1.10 to 1
8.	Receivables turnover ratio	8.58 times	10.57 times	9.70 times
9.	Average collection period	42.54 days	34.53 days	37.63 days
10.	Inventory turnover ratio	5.07 times	8.87 times	7.50 times
11.	Average sale period	71.99 days	41.15 days	48.67 days
Long-Term Solvency Measures
12.	Debt to assets	0.57 to 1	0.68 to 1	0.48 to 1
13.	Debt to equity	1.33 to 1	2.17 to 1	0.94 to 1
14	Times interest earned	20.36 times	10.10 times	10.70 times
Market Valuation Measures
15.	Market capitalization	$146,500,000,000	$100,700,000,000	$87,500,000,000
16.	Price-earnings ratio	12.48 times	16.04 times	14.60 times

It is important to note that different terms are often used in financial statements to describe the same item. For example, some companies use the term net revenues instead of net sales, and the income statement is often called the statement of earnings, or consolidated statement of earnings. Also be sure to review the income statement and balance sheet information for Coca-Cola. (All the dollar amounts given for Coca-Cola are in millions unless stated otherwise.)

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