INTERNAL ASSESSMENT (FINANCE/ACCOUNTING):Basic Types of Financial Ratios

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Strategic Management MGT603

Lesson 15

INTERNAL ASSESSMENT (FINANCE/ACCOUNTING)

Objectives:

Financial condition is often considered the single best measure of a firm's competitive position and

overall attractiveness to investors. Determining an organization's financial strengths and weaknesses is

essential to formulating strategies effectively. A firm's liquidity, leverage, working capital, profitability,

asset utilization, cash flow, and equity can eliminate some strategies as being feasible alternatives.

Financial factors often alter existing strategies and change implementation plans. After reading this

lecture, you will be able to know that what are the basics types of ratios and who business measure its

financial strength using these ratios analysis.

Finance/Accounting Functions

Determining financial strengths and weaknesses key to strategy formulation

Investment decision (Capital budgeting)

Financing decision

Dividend decision

According to James Van Horne, the functions of finance/accounting comprise three decisions: the

investment decision, the financing decision, and the dividend decision.

Financial ratio analysis is the most widely used method for determining an organization's strengths and

weaknesses in the investment, financing, and dividend areas. Because, the functional areas of business

are so closely related, financial ratios can signal strengths or weaknesses in management, marketing,

production, research and development, and computer information systems activities.

The investment decision, also called capital budgeting, is the allocation and reallocation of capital

and resources to projects, products, assets, and divisions of an organization. Once strategies are

formulated, capital budgeting decisions are required to implement strategies successfully. The financing

decision concerns determining the best capital structure for the firm and includes examining various

methods by which the firm can raise capital (for example, by issuing stock, increasing debt, selling

assets, or using a combination of these approaches). The financing decision must consider both short-

term and long-term needs for working capital. Two key financial ratios that indicate whether a firm's

financing decisions have been effective are the debt-to-equity ratio and the debt-to-total-assets ratio.

Dividend decisions concern issues such as the percentage of earnings paid to stockholders, the

stability of dividends paid over time, and the repurchase or issuance of stock. Dividend decisions

determine the amount of funds that are retained in a firm compared to the amount paid out to

stockholders.

Three financial ratios that are helpful in evaluating a firm's dividend decisions are the earnings-per-

share ratio, the dividends-per-share ratio, and the price-earnings ratio. The benefits of paying dividends

to investors must be balanced against the benefits of retaining funds internally, and there is no set

formula on how to balance this trade-off. For the reasons listed here, dividends are sometimes paid out

even when funds could be better reinvested in the business or when the firm has to obtain outside

sources of capital:

1. Paying cash dividends is customary. Failure to do so could be thought of as a stigma. A dividend

change is considered a signal about the future.

2. Dividends represent a sales point for investment bankers. Some institutional investors can buy only

dividend-paying stocks.

3. Shareholders often demand dividends, even in companies with great opportunities for reinvesting

all available funds.

4. A myth exists that paying dividends will result in a higher stock price.

Basic Types of Financial Ratios

Financial ratios are computed from an organization's income statement and balance sheet. Computing

financial ratios is like taking a picture because the results reflect a situation at just one point in time.

Comparing ratios over time and to industry averages is more likely to result in meaningful statistics that

can be used to identify and evaluate strengths and weaknesses. Trend analysis, illustrated in Figure, is a

useful technique that incorporates both the time and industry average dimensions of financial ratios.

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Table provides a summary of key financial ratios showing how each ratio is calculated and what each

ratio measures. However, all the ratios are not significant for all industries and companies. For example,

accounts receivable turnover and average collection period are not very meaningful to a company that

does primarily cash receipts business. Key financial ratios can be classified into the following five types:

Liquidity ratios measure a firm's ability to meet maturing short-term obligations. It includes:

Current ratio

Quick (or acid-test) ratio

Leverage ratios measure the extent to which a firm has been financed by debt.

Debt-to-total-assets ratio

Debt-to-equity ratio

Long-term debt-to-equity ratio

Times-interest-earned (or coverage) ratio

Activity ratios measure how effectively a firm is using its resources.

Inventory-turnover

Fixed assets turnover

Total assets turnover

Accounts receivable turnover

Average collection period

Profitability ratios measure management's overall effectiveness as shown by the returns generated on

sales and investment.

Gross profit margin

Operating profit margin

Net profit margin

Return on total assets (ROA)

Return on stockholders' equity (ROE)

Earnings per share

Price-earnings ratio

Growth ratios measure the firm's ability to maintain its economic position in the growth of the

economy and industry.

Sales

Net income

Earnings per share

Dividends per share

A Summary of Key Financial Ratios

Ratio

How Calculated

What It Measures

Liquidity Ratios

Current Ratio

Current

assets

The extent to which a firm can meet its

Current liabilities

short-term obligations

Quick Ratio

Current

assets

The extent to which a firm can meet its

minus

short-term obligations without relying

inventory

upon the sale of its inventories

Current liabilities

Leverage Ratios

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Debt-to-Total-

Total debt

The percentage of total funds that are

Assets Ratio

Total assets

provided by creditors

Debt-to-Equity

Total debt

The percentage of total funds provided

Ratio

Total stockholders'

by creditors versus by owners

equity

Long-Term

Long-term debt

The balance between debt and equity

Debt-to-Equity

Total stockholders'

in a firm's long-term capital structure

Ratio

equity

Times-Interest-

Profits before

The extent to which earnings can

Earned Ratio

interest

decline without the firm becoming

and taxes

unable to meet its annual interest costs

Total interest

charges

Activity Ratios

Inventory

Sales

Whether a firm holds excessive stocks

Turnover

Inventory of

of inventories and whether a firm is

finished goods

selling its inventories slowly compared

to the industry average

Fixed Assets

Sales

Sales productivity and plant and

Turnover

Fixed assets

equipment utilization

Total Assets

Sales

Whether a firm is generating a

Turnover

Total assets

sufficient volume of business for the

size of its asset investment

The average length of time it takes a

Accounts

Annual credit

sales

firm to collect credit sales (in

Receivable

Accounts

percentage terms)

Turnover

receivable

The average length of time it takes a

Average

Accounts

receivable

firm to collect on credit sales (in days)

Collection

Total credit

Period

sales/365 days

Profitability Ratios

Sales minus cost

The total margin available to cover

Gross Profit

of goods sold

operating expenses and yield a profit

Margin

Sales

Earnings before

Operating

interest and taxes

Profitability without concern for taxes

Profit Margin

(EBIT)

and interest

Sales

Net Profit

Net income

After-tax profits per dollar of sales

Margin

Sales

After-tax profits per dollar of assets;

Net income

Return on Total

Total assets

this ratio is also called return on

Assets (ROA)

investment (ROI)

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Return on

Net income

After-tax profits per dollar of

Stockholders'

Total stockholders'

stockholders' investment in the firm

Equity (ROE)

equity

Net income

Earning Per

Number of shares

Earnings available to the owners of

Share (EPS)

of common stock

common stock

outstanding

Market price per

Attractiveness of firm on equity

Price-Earnings

markets.

Ratio

Earnings per share

Growth Ratios

Sales

Annual percentage

Firm's growth rate in sales

growth in total

sales

Income

Annual percentage

Firm's growth rate in profits

growth in profits

Earnings Per

Annual percentage

Firm's growth rate in EPS

growth in EPS

Dividends Per

Annual percentage

Firm's growth rate in dividends per

growth

in dividends per

Limitations of Financial ratios:

Financial ratio analysis is not without some limitations. First of all, financial ratios are based on

accounting data, and firms differ in their treatment of such items as depreciation, inventory valuation,

research and development expenditures, pension plan costs, mergers, and taxes. Also, seasonal factors

can influence comparative ratios. Therefore, conformity to industry composite ratios does not establish

with certainty that a firm is performing normally or that it is well managed. Likewise, departures from

industry averages do not always indicate that a firm is doing especially well or badly. For example, a

high inventory turnover ratio could indicate efficient inventory management and a strong working

capital position, but it also could indicate a serious inventory shortage and a weak working capital

position.

It is important to recognize that a firm's financial condition depends not only on the functions of

finance, but also on many other factors that include:

Management, marketing, production/operations, research and development, and computer

information systems decisions;

Actions by competitors, suppliers, distributors, creditors, customers, and shareholders; and

Economic, social, cultural, demographic, environmental, political, governmental, legal, and

technological trends.

So financial ratio analysis, like all other analytical tools, should be used wisely.

Finance/Accounting Audit Checklist of Questions

Similarly as provided earlier, the following finance/accounting questions should be examined:

1. Where is the firm financially strong and weak as indicated by financial ratio analyses?

2. Can the firm raise needed short-term capital?

3. Can the firm raise needed long-term capital through debt and/or equity?

4. Does the firm have sufficient working capital?

Strategic Management MGT603

5. Are capital budgeting procedures effective?

6. Are dividend payout policies reasonable?

7. Does the firm have good relations with its investors and stockholders?

8. Are the firm's financial managers experienced and well trained?

Production/Operations

The production/operations function of a business consists of all those activities that transform inputs into

goods and services. Production/operations management deals with inputs, transformations, and

outputs that vary across industries and markets. A manufacturing operation transforms or converts

inputs such as raw materials, labor, capital, machines, and facilities into finished goods and services. As

indicated in Table, production/operations management comprises five functions or decision areas:

process, capacity, inventory, workforce, and quality.

The Basic Functions of Production Management

Function

Description

1. Process

Process decisions concern the design of the physical production

system. Specific decisions include choice of technology, facility

layout, process flow analysis, facility location, line balancing,

process control, and transportation analysis.

2. Capacity

Capacity decisions concern determination of optimal output levels

for the organization--not too much and not too little. Specific

decisions include forecasting, facilities planning, aggregate

planning, scheduling, capacity planning, and queuing analysis.

3. Inventory

Inventory decisions involve managing the level of raw materials,

work in process, and finished goods. Specific decisions include

what to order, when to order, how much to order, and materials

handling.

4. Workforce

Workforce decisions are concerned with managing the skilled,

unskilled, clerical, and managerial employees. Specific decisions

include job design, work measurement, job enrichment, work

standards, and motivation techniques.

5. Quality

Quality decisions are aimed at ensuring that high-quality goods and

services are produced. Specific decisions include quality control,

sampling, testing, quality assurance, and cost control.

Source: Adapted from R. Schroeder, Operations Management (New York: McGraw-Hill Book

Co., 1981): 12.

Production/operations activities often represent the largest part of an organization's human and capital

assets. In most industries, the major costs of producing a product or service are incurred within

operations, so production/operations can have great value as a competitive weapon in a company's

overall strategy. Strengths and weaknesses in the five functions of production can mean the success or

failure of an enterprise.

Many production/operations managers are finding that cross-training of employees can help their firms

respond to changing markets faster. Cross-training of workers can increase efficiency, quality,

productivity, and job satisfaction.

There is much reason for concern that many organizations have not taken sufficient account of the

capabilities and limitations of the production/operations function in formulating strategies. Scholars

contend that this neglect has had unfavorable consequences on corporate performance in America. As

shown in Table, James Dilworth outlined several types of strategic decisions that a company might

make with production/operations implications of those decisions. Production capabilities and policies

can also greatly affect strategies:

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Given today's decision-making environment with shortages, inflation, technological booms, and

government intervention, a company's production/operations capabilities and policies may not be able

to fulfill the demands dictated by strategies. In fact, they may dictate corporate strategies. It is hard to

imagine that an organization can formulate strategies today without first considering the constraints and

limitations imposed by its existing production/operations structure.

Impact of Strategy Elements on Production Management

Concomitant Conditions That May Affect the

Possible Elements of

Operations Function and Advantages and

Strategy

Disadvantages

1. Compete as low-cost

Discourages competition

provider of goods or

Broadens market

services

Requires longer production runs and fewer product

changes

Requires special-purpose equipment and facilities

2. Compete as high-quality

Often possible to obtain more profit per unit, and

provider

perhaps more total profit from a smaller volume of

sales

Requires more quality-assurance effort and higher

operating cost

Requires more precise equipment, which is more

expensive

Requires highly skilled workers, necessitating higher

wages and greater training efforts

3. Stress customer service

Requires broader development of service people and

service parts and equipment

Requires rapid response to customer needs or

changes in customer tastes, rapid and accurate

information system, careful coordination

Requires a higher inventory investment

4. Provide rapid and

Requires versatile equipment and people

frequent introduction of

Has higher research and development costs

new products

Has high retraining costs and high tooling and

changeover in manufacturing

Provides lower volumes for each product and fewer

opportunities for improvements due to the learning

curve

5. Strive for absolute

Requires accepting some projects or products with

growth

lower marginal value, which reduces ROI

Diverts talents to areas of weakness instead of

concentrating on strengths

6. Seek vertical integration

Enables company to control more of the process

May not have economies of scale at some stages of

process

May require high capital investment as well as

technology and skills beyond those currently

available within the organization

7. Maintain reserve

Provides ability to meet peak demands and quickly

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capacity for flexibility

implement some contingency plans if forecasts are

too low

Requires capital investment in idle capacity

Provides capability to grow during the lead time

normally required for expansion

8. Consolidate processing

Can result in economies of scale

(Centralize)

Can locate near one major customer or supplier

Vulnerability: one strike, fire, or flood can halt the

entire operation

9. Disperse processing of

Can be near several market territories

service (Decentralize)

Requires more complex coordination network:

perhaps expensive data transmission and duplication

of some personnel and equipment at each location

If each location produces one product in the line,

then other products still must be transported to be

available at all locations

If each location specializes in a type of component

for all products, the company is vulnerable to strike,

fire, flood, etc.

If each location provides total product line, then

economies of scale may not be realized

10. Stress the use of

Requires high capital investment

mechanization,

Reduces flexibility

automation, robots

May affect labor relations

Makes maintenance more crucial

11. Stress stability of

Serves the security needs of employees and may

employment

develop employee loyalty

Helps to attract and retain highly skilled employees

May require revisions of make-or-buy decisions, use

of idle time, inventory, and subcontractors as

demand fluctuates

Source: Production and Operations Management: Manufacturing and Nonmanufacturing, Second

permission of Random House, Inc.

Production/Operations Audit Checklist of Questions

Questions such as the following should be examined:

1. Are suppliers of raw materials, parts, and subassemblies reliable and reasonable?

2. Are facilities, equipment, machinery, and offices in good condition?

3. Are inventory-control policies and procedures effective?

4. Are quality-control policies and procedures effective?

5. Are facilities, resources, and markets strategically located?

6. Does the firm have technological competencies?

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