Question

A. In learning about ratios, we could simply study the different types or categories of ratios,
or we could use ratios to answer some important questions about a firm's operations. We
prefer the latter approach and have chosen the following four questions as a map in using
financial ratios:
1. How liquid is the firm?
2. Is management generating adequate operating profits on the firm's assets?
3. How is the firm financing its assets?
4. Are the owners (stockholders) receiving an adequate return on their investment?
Let's look at each of these questions in turn. In doing so, we will use the McDonald's Corporation
to illustrate the use of ratios in answering these questions. For ease of reference, we have again
shown McDonald's financial statements in followings Tables.
McDonald's Corporation 2018 Income Statement ($ Millions)
Sales $11,508
Cost of goods sold 6,537
Gross profits $ 4,971
Marketing expenses and general
and administrative expenses $ 1,832
Depreciation expense 345
Total operating expenses $ 2,177
Operating profits $ 2,794
Interest expenses 387
Earnings before taxes $ 2,407
Income taxes 765
Net income before preferred stock dividends $ 1,642
Preferred stock dividends 25
Net income available to common stockholders $ 1,617

McDonald's Corporation December 31, 2018 Balance Sheet ($ Millions)Assets
Cash $ 341
Accounts receivables 484
Inventories 71
Prepaid expenses 247
Total current assets $ 1,143
Gross fixed assets $20,088
Accumulated depreciation 5,127
Net fixed assets $14,961
Investments 702
Other assets 1,436
Total assets $18,242
Liabilities and Equity
Liabilities (debt):
Short-term notes payable $ 1,629
Accounts payable 651
Taxes payable 53
Accrued expenses 652
Total current liabilities $ 2,985
Long-term debt 6,325
Total liabilities $ 9,310
Equity:
Preferred stock $ 80
Common stock:
Par value and paid in capital $ 708
Retained earnings 11,927
Treasury stock (3,783)
Total common equity $ 8,852
Total equity $ 8,932
Total liabilities (debt) and equity $18,242

Calculate and interpret the financial ratios for 2018 corresponding to the industry norms
provided as follows:
INDUSTRY NORMS
Current ratio 0.70
Inventory turnover 35 times
Total asset turnover 1.9
Operating profit margin 6.1%
Operating income return on investment 11.6%
Debt ratio 69%
Fixed asset turnover 3.2
Return on equity 12.78%

Answer 1

Ratio	Formula	McDonald's	Industry
Current Ratio	Total Current Assets / Total Current Liabilities	0.38	0.70
Inventory Turnover	Cost of Goods Sold / Inventories	92 times	35 times
Total Asset Turnover	Sales / Total Assets	0.63	1.9
Operating Profit Margin	Operating Profit / Sales	24.3 %	6.1 %
Operating Income Return on Investment	Operating Profit / Total Assets	15.3 %	11.6 %
Debt Ratio	Total Liabilities / Total Assets	51 %	69 %
Fixed Asset Turnover	Sales / Net Fixed Assets	0.77	3.2
Return on Equity	Net Income Available to Common Shareholders / Total Common Equity	18.3 %	12.78 %

1. Current ratio of 0.38 is far lower as compared to industry. But the inventory turnover for McDonald's is more than double that of the industry average. Therefore, liquidity position appears to be alright, as inventory gets sold every 3.97 days. It would have been useful if the quick ratio for the industry was available as well.

2. While the operating profit margin for industry is only 6.1 %, that of McDonald's is 24.3%, i.e four times that of industry. Also, the operating profit margin on Investment of 15.3 % is substantially higher than the industry average of 11.6 %.

3. The firm is financing its assets 49 % through equity, and 51 % through debt. Financial leverage is far lower than the average peer in industry. Therefore, the firm has higher financial flexibility compared to industry.

4. Yes, while the average player in the industry generates 12.78 % in return for the stockholders, the firm generates 18.3 %.