Calculating the "Big Three" financial ratios is only half the fun.
The real excitement doesn't start until you're using them to solve a mystery. Calculating a ratio is like uncovering a new clue. Your job is to study all the clues and figure out why something is happening.
Calculating ratios and using them to solve financial mysteries is something you'll do in the real world. From them, you'll get strategic insights about your own company and its competitors. Then you can plot how you'll exploit your competitive advantage to the detriment of those competitors.
You might also use ratio analysis to figure out whether a new customer or supplier will be a good one. Or you might study some ratios as part of deciding whether to accept a company's job offer. Nothing would be worse than landing your dream job only to have your employer go bankrupt in six months.
So, let's look at some of the things you'll want to know and how ratio analysis can be a "tool" for getting the answers.
First, standing alone, a ratio isn't very interesting. It's just a "frozen" moment of data that doesn't tell you anything. Ratios are only useful when (1) they're consistently computed and (2) they're compared to ratios from competitors or other time periods.
Be sure you're comparing apples with apples. When looking at competitors, double-check that the accounts you're analyzing are all defined in the same way. "Current Liabilities," for example, has a generally accepted meaning; it includes only debts coming due during the next year. But verify, if you can, that all the companies in your analysis use the same definition.
Now let's look at the three "big things" you want to know and how the Big Three Ratios will tell you all about them.
LIQUIDITY
A business's relative liquidity is a measure of how easily or quickly its assets can be converted to cash and used to pay off debts.
You'll always want to know if the business can pay its Current Liabilities, that is, debts that must be paid during the next year. Answering this question involves comparing the amount of Current Liabilities with the amount of Current Assets, which are assets that can be converted into cash within one year. This comparison is the "Current Ratio."
A firm with a Current Ratio of less than 1:1 that has been trending downward might be having cash flow problems unless there's a good explanation. Is it explained by seasonal factors or will they soon be getting an influx of cash? Drill a little deeper for answers. Is the company falling behind in paying its trade debt? Or are accounts receivable delinquencies growing?
Conversely, a "high" Current Ratio (2:1 or more) might also trigger questions. Surplus cash usually can be invested only at low rates of return. Could any extra cash-on-hand be invested in assets that might earn a higher rate of return? Should any extra cash be paid as a dividend to the shareholders?
LEVERAGING (CAPITAL STRUCTURE COMPOSITION)
A firm's capital structure is the "mix" of financing sources it uses for its operating and capital needs.
There are only two sources: (1) Debt - cash borrowed from lenders such as banks or finance companies or (2) Equity - cash invested by stockholders or earnings not paid out as dividends.
The biggest difference between the two sources is Debt (a loan) has to be paid back but Equity doesn't. Loans also always charge interest in addition to repaying the borrowed funds. Loans are repaid by either (a) installment payments of interest and principal or (b) a lump-sum payment on a specific date of the loan amount plus interest.
If a loan isn't paid when due, the lender can take legal actions that may lead to the business's bankruptcy. It's necessary to know how much of a firm's capital structure is debt versus equity.
The degree to which a firm is leveraged is measured by calculating its Debt-to-Equity Ratio; the ratio will tell you the relative portions of debt and equity in the firm's capital structure.
Debt repayment obligations are a fixed expense. If the firm is growing and able to spread the fixed expenses of borrowing over an increasing volume of sales, profits will rise exponentially. The converse is also true; highly-leveraged firms will have a comparatively high break-even point, which means a downturn in sales quickly produces losses. The ability of highly-leveraged firms (Debt-to-Equity Ratio of 2:1 or higher) to make installment payments on their loans, and repay them when due, should be carefully evaluated (something the sub-prime mortgage lenders didn't do).
RETURN-ON-EQUITY
Is the firm's management doing a good job operating its assets? Are the owners (the stockholders) earning a competitive rate of return? How does the rate of return they're earning compare with other investment opportunities? Should the firm's management be rewarded with bonuses for earning above-average returns? Or should they be replaced because competitors are earning higher rates of return for their stockholders?
All these questions can be answered by comparing a firm's Net Income with its Equity and calculating its Return-on-Equity Ratio.
Computing and analyzing the ROE Ratio is sometimes problematic, however. Net Income, as we've learned, is often effected by one-time or special adjustments that have nothing to do with current and future operations. Profits may be a better measure, but firms may not consistently classify revenues or expenses.
Also, should you use the amount of equity at the beginning or end of a year, for example, or an average? What you do is not as important as being consistent in how you do it. Pick one approach and stick with it throughout your analysis.
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