Financial Ratios Calculations

Financial Ratio Calculations Overview:

Financial statements are generally used for strategic decision-making purpose. Financial statements are used by everyone from business owners to accountants, investors, and anyone else with an interest in the financial activities of enterprise. Business owners, accountants, auditors, and investors take the data that is listed in the financial statements for a company and then they perform a mathematical analysis with that data by using financial ratios. Financial ratios are used to measure a company's productivity. These ratios indicated productivity in terms of whichever operation is being evaluated- this may include how well using assets, profits generated from each unit of sale, rate of inventory turn over, etc. The ratios are indicator for current financial health as well as a company's potential.

 Learning Objectives You should be able to understand the difference between liquidity ratios and solvency ratios. You should be able to understand how to analyze trends and the use of trend analysis is a very powerful tool for business owners as well as investors. You should be able to effectively explain if a company is using its assets efficiently and if it is making the best strategic decisions using its capital.

Ratio Analysis on the Balance Sheet:

Liquidity: Current Ratio- The current ratio is used to measure the ability of a business to pay its current liabilities as they become due. Current ratio is more or less a measure of short-term liquidity, which will yield the statistical probability of a company's ability to pay its debt obligations within the next 12 months. In order to derived the current ratio you must take the current assets divided by the current liabilities.

 Current Ratio Formula Current Ratio = Current Assets/ Current Liabilities

As you can see in the example below we have compared WH3 Corp. to two other global media companies, which are Time Warner, and News Corp. who owns the Fox broadcasting network. Generally a strong current ratio is considered to be around 1.0 which indicates that the current assets are equal to the current liabilities, or in other words that the business can pay 100% of its current liabilities.

 2010 (\$ in Millions) WH3 Corp. News Corp Time Warner Current Assets \$ 12,225 \$18,024 \$ 13,138 Current Liabilities \$ 11,000 \$ 8,862 \$ 8,643 Current Ratio 1.11 2.03 1.52

In 2010 WH3 Corp. had a stated current ratio of 1.11, which is generally a little bit low when compared to news Corp. who had a current ratio of 2.03 and Time Warner who had a current ratio 1.52. All three companies appeared to have adequate current ratios with no liquidity problems. It is important to note that a current ratio that is above 2.0 indicates that a company has twice as many current assets as it does current liabilities which can imply that the company is not using its current assets as efficiently as possible. This means that if it has too much cash or other current assets then perhaps it is not growing were expanding its business at an adequate rate.

Solvency: Debt Ratios- The debt ratio is used to indicate what percentage of the business is financed with that which is also called liabilities. The debt ratio has inability to measure the solvency or rather accompanies financial ability to repay its long-term debt when it becomes due. Taking the total liabilities divided by the total assets as a percentage derives the debt ratio. Generally when a business has a low debt ratio there is stronger solvency within the business and less financial risk. Conversely high debt ratios which for some businesses can exceed more than 100% with generally indicate that a company might be caring too much of a debt load and that it will not be able to pay back the principal amount of debt plus the interest that it goes on that debt thereby allowing creditors and lenders to claim any collateral that is owned by the business what forced the business into bankruptcy. Difference between the debt ratio and the current ratio is that the debt ratio is measuring solvency whereas the current ratio is measuring liquidity. This means that the current ratio is looking for the ability to pay debt that is due within the next 12 months and the debt ratio measure solvency which refers to the ability of the company to be able pay amounts of debt that are owed over a longer term than 12 months.

 Debt Ratio Formula Debt Ratio = Total Liabilities / Total Assets

 2010 (\$ in Millions) WH3 Corp. News Corp Time Warner Current Assets \$ 29,864 \$28,843 \$ 33,579 Current Liabilities \$ 69,206 \$ 54,384 \$ 66,524 Current Ratio 43.2% 53.0% 50.5%

Once again secure the debt ratios for WH3 Corp., News Corp., and Time Warner. WH3 Corp. has a debt ratio of approximately 43%, which implies that 43% of the assets for WH3 Corp. are financed with that. Therefore this means that approximately 57% of the assets for WH3 Corp. financed through equity. We have come to this conclusion by taking 100% and subtracting the 43% debt ratio. Similarly for News Corp. there's a 53% debt ratio, which indicates that approximately 53% of its assets are financed by debt 47% of its assets, are financed through equity. Time Warner has a 51% debt ratio, which falls in the middle of these two companies, thereby making News Corp. a more financially risky investment.

Trend Analysis- By using the trend analysis this can help us compare the financial amounts more recent years two older years, which are also known as base years. In this context the base year is the earliest year that is being used for an analysis basis. This type of trend analysis is intended to measure the percentage change that occurs from the base year forward in order to show trends of growth or decline in the financial position of the business.

 Trend Index Formula Trend Index = (Current Amount / Base Year Amount) x (100)

 WH3 Corp. 2010 2009 2008 2007 (\$ Millions) \$ Trend \$ Trend \$ Trend \$ Trend Current Assets 12,225 108 11,889 105 11,667 103 11,314 100 PPE, net 17,806 102 17,597 101 17,532 101 17,433 100 Goodwill + Intangibles 29,181 119 23,930 97 24,579 100 24,579 100 Other Assets 9,994 131 9,701 128 8,720 115 7,602 100 Total Assets 69,206 114 63,117 104 62,497 103 60,928 100 Current Liabilities 11,000 97 8,934 78 11,591 102 11,391 100 Noncurrent Liabilities 18,864 100 18,758 100 18,583 99 18,784 100 Common Stock 28,736 119 27,038 112 26,546 110 24,207 100 Retained Earnings 34,327 Interested in learning more? Why not take an online class in Understanding Financial Statements? 138 31,033 125 28,413 115 24,805 100 Other S/Equity (23,721) 130 (22,646) 124 (22,636) 124 (18,259) 100 Total Liabilities and Stockholder's Equity 69,206 114 63,117 104 62,497 103 60,928 100

Generally an increase from the base year is set above 100 will decrease will be represented below 100. As an example look at the current assets increased from \$11,314 in 2007 to the 2011 current assets of \$12,225 which indicates the trend index of 108. More simply put this is an 8% increase since 2007, this is derived by taking (108-100). These trend indexes will reflect the changes sometimes referred to as deltas from the base year used in the analysis rather than the previous year. Upon further analysis of this table from 2007 to the more recent period of 2011 we can gather that the total assets increased by 14%, which is represented as a trend figure of 114. Conversely the noncurrent liabilities hardly even changed. Common stock has increased by 19% while the retained earnings also increased even more at a trend of 38%. By using this type of analysis and water production we are able to tease out information such as an increase that is greater than the increase in assets can indicate that asset growth primarily financed by equity rather than being financed by liabilities. By using this type of analysis we can see that WH3 Corp.'s assets have grown but they have grown slowly at a rate of 4.7% which is derived by taking 14% and dividing that by the 3 year time period, where (14%/3 = 4.7%).

Common-size Balance Sheet- The common sized balance sheet is designed to measure each of the items on the balance sheet as a percentage of the total assets. In order to develop the common-size balance sheet you must divide each of the numerical items that are listed on the balance sheet for a given accounting period by the total assets for the same accounting period and then multiple by 100 to get a percentage value. This common-size method can make it slightly more difficult to compare different companies to each other because some companies are much larger and more diverse so a 30% ratio in the current assets category of one business might translate to \$1,000,000 but for another larger company a 30% ratio in the current assets category could potentially translate into \$85,000,000.

 2010 WH3 Corp. News Corp Time Warner (\$ Millions) \$ % \$ % \$ % Current Assets 12,225 18% 18,024 33% 13,138 20% PPE, net 17,806 26% 5,980 11% 3,874 6% Goodwill + Intangibles 29,181 42% 22,055 41% 40,313 60% Other Assets 9,994 14% 8,325 15% 9,199 14% Total Assets 69,206 100% 54,384 100% 66,524 100% Current Liabilities 11,000 16% 8,862 16% 8,643 13% Noncurrent Liabilities 18,864 27% 19,981 37% 24,936 38% Common Stock 28,736 41% 17,434 32% 157,162 236% Retained Earnings 34,327 50% 7,679 14% (94,557) -142% Other S/Equity (23,721) -34% 428 1% (29,660) -45% Total Liabilities and Stockholder's Equity 69,206 100% 54,384 100% 66,524 100%

Ratio Analysis on the Income Statement:

Return on Assets- One of the most commonly used financial ratios is the return on assets ratio. The return on assets is used to measure how efficiently and productively a business strategically uses its assets in order to generate profit. One of the nice things about this ratio is that it is fairly flexible meaning that it can be compared among other industries, companies, as well as investments. Similarly to the asset turnover ratio and the return on assets ratio compare an income statement amount to the total assets listed for the given accounting period.

 Return on Assets Formula Return on Assets = Net Income / Total Assets

In this section we will be comparing WH3 Corp. to Sears as well as eBay in order to do a comparative analysis for the return on assets between these businesses.

 Return on Assets WH3 Corp. Sears Corp. eBay (\$ Millions) 2006 2005 2004 2006 2005 2004 2006 2005 2004 Net Income 1,152 902 645 150 297 99 1,801 2,389 1,779 A Total Assets 18,797 13,813 8,314 24,268 24,808 25,342 22,004 18,408 15,592 B Return on Assets 6.1% 6.5% 7.8% 0.6% 1.2% 0.4% 8.2% 13.0% 11.4% A/B

Return on Sales- The return on sales ratio is also referred to in business as the net profit margin which measures the profitability from each dollar of revenue and therefore expresses the net income as a percentage. This is a very important metric as it can show how effectively a company derives its net income from its net sales. This challenges the management team of business to see how well they can control expenses while simultaneously maximizing the amount of net income it turns for each dollar of revenue. The formula for calculating the return on sales is listed below.

 Return on Sales Formula Return on Sales = Net Income / Sales Revenue

In this section we will be comparing WH3 Corp. to Sears as well as eBay in order to do a comparative analysis for the return on sales between these businesses.

 Return on Sales WH3 Corp. Sears Corp. eBay (\$ Millions) 2006 2005 2004 2006 2005 2004 2006 2005 2004 Net Income 1,152 902 645 150 297 99 1,801 2,389 1,779 A Sales Revenue 34,204 24,509 19,166 43,326 44,043 46,770 9,156 8,727 8,541 B Return on Sales 3.4% 3.7% 3.4% 0.3% 0.7% 0.2% 19.7% 27.4% 20.8% A/B

Performing the return on sales analysis the ratio indicates that WH3 Corp.'s sales performance figures remain fairly steady alternating between 3.4% and 3.7%. The return on sales Sears however is extremely low with the ratio of less than 1%. As for eBay they have comparatively an incredibly high return on sales that range from 20.8% in 2008 an increase to 27.4% in 2009 with the slight drop in 2010 ending the year with the total return sales percentage of 19.7%. The return on sales for eBay puts it far above any of the other companies in the analysis. It is important to note that through thorough investigation of the financial statement ratios and the amounts that are used to derive the ratios sometimes a diligent user of this information will be able to tease out the variables that were previously on scene. For instance historical and situational awareness of the business may affect the sales revenue if the company that you are examining is based in California and recently sustained an earthquake wherein 90% of their inventory was damaged an unsellable. This could indicate that the operations of the company and the strategic direction of the management team our fine however the business is currently dealing with the results of a natural disaster that left them unable to sell 90% of their inventory therefore revenues would be down by a corresponding 90%. Finally it is important to note that if you are doing analysis for investing many analysts will exclude the research and development expense when computing financial ratios such as return on sales because research and development is not considered a real expense instead it is considered as an investment that will generate future revenue.

Asset Turnover Ratio- The asset is designed to measure how efficiently a company is able to use its assets to generate revenue over the accounting period. Assets are a necessity for a company and a necessity for generating revenue and cash flow. An example of this would be a computer company that has to have test equipment and test laboratories in order to make new microchips, test new computer designs, etc.

 Asset Turnover Formula Asset Turnover = Sales Revenue / Total Assets

 Asset Turnover WH3 Corp. Sears Corp. eBay (\$ Millions) 2006 2005 2004 2006 2005 2004 2006 2005 2004 Sales Revenue 34,204 24,509 19,166 43,326 44,043 46,770 9,156 8,727 8,541 A Total Assets 18,797 13,813 8,314 24,268 24,808 25,342 22,004 18,408 15,592 B Asset Turnover 1.8 1.8 2.3 1.8 1.8 1.8 0.4 0.5 0.5 A/B

The asset turnover ratio will measure how efficiently a business is able to use limited assets as inputs in order to generate revenue as outputs. Notice that in 2010 for every one dollar of assets WH3 Corp. was able to generate \$1.8 in sales revenue. The decrease in overall sales revenue from 2008 2009 indicates that WH3 Corp. is not able to use its assets as efficiently as possible therefore making it less productive and generating less revenue in 2009 as well as 2010. Due to the fact that the use of productive assets is a worthwhile metric investors should look not only for high asset turnover ratios but asset turnover ratios that increase year on year.

 KEY POINTS REVIEW Financial ratios may be the result of numbers that seem odd so it is important to also look at historical and situational variables that might have affected the business at the time of reporting. Not all ratios can be used equally. This means that some ratios will allow for comparisons of multiple businesses across different industries, while some ratios will be more narrowly focused and will not be able to accurately compare multiple companies. Trend analysis is intended to measure the percentage change that occurs from the base year forward in order to show trends of growth or decline in the financial position of the business.