USING FINANCIAL RATIOS
Some important points to keep in mind when using financial ratios are:
• Whereas all balance sheet numbers are end-of-period numbers, all income statement numbers relate to the entire period. For example, when calculating the ratio for Accounts Receivable Turnover, we use a numerator of Credit Sales, which is an entire-period number from the income statement, and a denominator of Accounts Receivable, which is an end-of-period number from the balance sheet. To make this an apples-to-apples ratio, the Accounts Receivable can be represented by an average of the beginning-of-year and end-of-year figures for Accounts Receivable. This average is closer to a mid-year estimate of Accounts Receivable and therefore is more comparable to the entire-period numerator, Credit Sales. Because using averages of the beginning-of-year and end-of-year figures for balance sheet numbers helps to make ratios more of an apples-to-apples comparison, averages should be used for all balance sheet numbers when calculating financial ratios.
• Financial ratios can be no more reliable than the data with which the ratios were calculated. The most reliable data is from audited financial statements, if the audit reports are clean and unqualified.
• Financial ratios cannot be fully considered without yardsticks of comparison. The simplest yardsticks are comparisons of an enterprise’s current financial ratios with those from previous periods. Companies often provide this type of information in their financial reporting. For example, Apple Computer Inc., recently disclosed the following financial quarterly information, in millions of dollars:
This table compares four successive quarters of information, which makes it possible to see the latest trends in such important items as Sales, and Gross Margin and Operating Income percentages. Other types of comparisons of financial ratios include:
1. Comparisons with competitors. For example, the financial ratios of Apple Computer could be compared with those of Compaq, Dell, or Gateway.
2. Comparisons with industry composites. Industry composite ratios can be found from a number of sources, such as:
a. The Almanac of Business and Industrial Financial Ratios, authored by Leo Troy and published annually by Prentice-Hall (Paramus, NJ). This publication uses Internal Revenue Service data for 4.6 million U.S. corporations, classified into 179 industries and divided into categories by firm size, and reporting 50 different financial ratios.
b. Risk Management Associates: Annual Statement Studies. This is a database compiled by bank loan officers from the financial statements of more than 150,000 commercial borrowers, representing more than 600 industries, classified by business size, and reporting 16 different financial ratios. It is available on the Internet at www.rmahq.org.
c. Financial ratios can also be obtained from other firms who specialize in financial information, such as Dun & Bradstreet, Moody’s, and Standard & Poor’s.