In-depth Notes on Ratio Analysis

Ratio Analysis

• Definition: Ratio analysis expresses the relationship among selected items of financial statement data, providing insights into a company's performance and financial health.
• Key Points:
  • A single ratio by itself is not informative without context.
  • Ratios can be categorized into three main types: profitability, liquidity, and solvency.

Profitability Ratios

• Purpose: Measure the income or operating success of a company for a specified period.
• Basic formula: \text{Net Income} = \text{Total Revenue} - \text{Total Expenses}
  • Indicates how well a company generates profit relative to revenue or assets.

Liquidity Ratios

• Purpose: Measure a company's short-term ability to meet maturing obligations and unexpected cash needs.
• Common Measures:
  • Current Ratio:
    \text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}}
  • Indicates how many dollars of current assets are available for each dollar of current liability.
  • Working Capital:
    \text{Working Capital} = \text{Current Assets} - \text{Current Liabilities}
  • Represents the liquidity available to cover short-term liabilities.
• Example: Best Buy had working capital in 2020 of $797 million, calculated as: 8,857 - 8,060 = 797
  • For 2020, Best Buy's current ratio was 1.18:1, meaning it has $1.18 of current assets for every $1 of current liabilities.

Using a Classified Balance Sheet

Best Buy Example (In millions, Feb 1, 2020, and Feb 3, 2019)

• Assets:

  • Total Current Assets:
  • 2020: 8,857
  • 2019: 8,870
  • Total Assets:
  • 2020: 15,591
  • 2019: 12,901

• Liabilities and Stockholders' Equity:

  • Total Current Liabilities:
  • 2020: 8,060
  • 2019: 7,513
  • Total Liabilities:
  • 2020: 12,112
  • 2019: 9,595
  • Total Stockholders' Equity:
  • 2020: 3,479
  • 2019: 3,306

Solvency Ratios

• Purpose: Measure a company's ability to survive over a long period and fulfill long-term obligations.
• Key Concept:
  • Higher debt-to-equity ratio indicates lower solvency.
  • Debt to Assets Ratio Formula:
    \text{Debt to Assets Ratio} = \frac{\text{Total Liabilities}}{\text{Total Assets}}
  • Indicates the proportion of a company's assets that are financed through debt.
• Example: Best Buy's debt to assets ratio in 2020 was 74%, meaning 74% of its assets were financed through debt.

Application of Ratios: Steno Corporation

Data for Calculation (2027 and 2026)

• Assets:
  • Total assets 2027: 70,700
  • Total assets 2026: 67,900
• Liabilities:
  • Total liabilities 2027: 29,100
  • Total liabilities 2026: 36,900
• Calculating Ratios:
  • Working Capital:
    a. Current Assets 2027: 6,700
    b. Current Liabilities 2027: 4,100
  • Working Capital 2027: 2,600
  • Current Ratio 2027: 1.63:1
  • Signifies an increase in liquidity compared to 1.26:1 in 2026.
  • Debt to Assets Ratio:
  • 2027: 41%
  • 2026: 54%
  • Indicates an improvement in solvency as the ratio decreased.