Question

What information from the 2017 and 2018 financial statements for both Dow Jones and Nasdaq, prepares two financial ratios for each of the following categories: liquidity ratios, asset management ratios, and profitability ratios. You should have a total of six ratios for each stock, per year. What challenges, strengths, or weaknesses do you see?

Answer 1

A)Liquidity Ratio

The liquidity ratios are a result of dividing cash and other liquid assets by the short term borrowings and current liabilities. ... Most common examples of liquidity ratios include current ratio, acid-test ratio

Current Ratio

The current ratio (also known as a working capital ratio) is a popular tool to evaluate the short-term solvency position of a business. Short-term solvency refers to the ability of a business to pay its short-term obligations when they become due. Short term obligations (also known as current liabilities) are the liabilities payable within a short period of time, usually one year.

The current ratio is computed by dividing total current assets by total current liabilities of the business. This relationship comprises two components i.e., current assets and current liabilities. Both components are available from the balance sheet of the company.

a)Challenges

The current ratio is a useful test of the short-term-debt paying ability of any business. A ratio of 2:1 or higher is considered satisfactory for most companies but analysts should be very careful while interpreting it. Simply computing the ratio does not disclose the true liquidity of the business because a high current ratio may not always be a green signal. It requires a deep analysis of the nature of individual current assets and current liabilities. A company with a high current ratio may not always be able to pay its current liabilities as they become due if a large portion of its current assets consists of slow-moving or obsolete inventories. On the other hand, a company with a low current ratio may be able to pay its current obligations as they become due if a large portion of its current assets consists of highly liquid assets i.e., cash, bank balance, marketable securities, and fast-moving inventories. Consider the following example to understand how the composition and nature of individual current assets can differentiate the liquidity position of two companies having the same current ratio figure.

b)Strength

• The current ratio helps in understanding how cash-rich a company is. It helps us gauge the short-term financial strength of a company. Higher the ratio, the more stable the company is. Lower the ratio, the greater is the risk of liquidity associated with the company.
• The current ratio gives an idea of a company’s operating cycle. It helps in understanding how efficient the company is in selling off its products; that is, how quickly is the company able to convert its inventory or current assets into cash. Knowing this, a company can optimize its production. This enables the company to plan inventory storage mechanisms and optimize the overhead costs.

c)Weakness

• Using this ratio on a standalone basis may not be sufficient to analyze the liquidity position of the company as it relies on the number of current assets instead of the quality of the asset.
• The current ratio includes inventory in the calculation, which may lead to the overestimation of the liquidity position in many cases. In companies, where higher inventory exists due to fewer sales or obsolete nature of the product; taking inventory under calculation may lead to displaying incorrect liquidity health of the company.
• In companies where sales are seasonal; you may see a reduced current ratio in some months and an increased ratio in the other.

• Using this ratio on a standalone basis may not be sufficient to analyze the liquidity position of the company as it relies on the number of current assets instead of the quality of the asset.
• The current ratio includes inventory in the calculation, which may lead to the overestimation of the liquidity position in many cases. In companies, where higher inventory exists due to fewer sales or obsolete nature of the product; taking inventory under calculation may lead to displaying incorrect liquidity health of the company.
• In companies where sales are seasonal; you may see a reduced current ratio in some months and an increased ratio in the other.

Acid Test Ratio

The acid-test, or quick ratio, compares a company's most short-term assets to its most short-term liabilities to see if a company has enough cash to pay its immediate liabilities, such as short-term debt. The acid-test ratio disregards current assets that are difficult to liquidate quickly such as inventory.

a)Challenges

The acid-test ratio is a strong indicator as to whether a company has enough short-term assets on hand to cover its immediate liabilities. Also known as the quick ratio, the acid-test ratio is a liquidity ratio that measures a company's ability to pay its current liabilities with its quick or current assets.

b)Strength

• The acid test ratio removes the inventory from the calculation, which may not always be considered liquid, thereby giving a more appropriate picture of the company’s liquidity position.
• Since inventory is excluded from current assets; bank overdraft and cash credit are removed from current liabilities as they are usually secured by inventory thereby making the ratio more meaningful in arriving at the liquidity position of the company.
• Valuation of inventory can be tricky and it may not always be at marketable value. Thus, the acid test ratio is not handicapped as there is no need for the valuation of the inventory.

c)Weakness

• Using this ratio on a standalone basis may not be sufficient to analyze the liquidity position of the company. A comparative analysis with the peers and industry standard may be required for effective analysis.
• This ratio removes inventory from the calculation, which may not be appropriate for businesses where inventory can be valued at a marketable price easily. It should rather be included than excluded to arrive at the liquidity position of the company.
• This ratio may not be a good indicator for all business models for showing short term solvency because if companies with usually higher inventory, like supermarkets exclude inventory to arrive at liquidity position, it may not be essentially correct to do so.

B)Asset Management Ratios

Analysis of asset management ratios tells how efficiently and effectively a company is using its assets in the generation of revenues. They indicate the ability of a company to translate its assets into sales. Asset management ratios are also known as asset turnover ratios and asset efficiency ratios.

Asset Turnover Ratio

The asset turnover ratio measures the value of a company's sales or revenues relative to the value of its assets. The asset turnover ratio can be used as an indicator of the efficiency with which a company is using its assets to generate revenue.

a)Challenges

Typically, the asset turnover ratio is calculated on an annual basis. The higher the asset turnover ratio, the better the company is performing, since higher ratios imply that the company is generating more revenue per dollar of assets. The asset turnover ratio tends to be higher for companies in certain sectors than in others. Retail and consumer staples, for example, have relatively small asset bases but have high sales volume – thus, they have the highest average asset turnover ratio. Conversely, firms in sectors such as utilities and real estate have large asset bases and low asset turnover. Since this ratio can vary widely from one industry to the next, comparing the asset turnover ratios of a retail company and a telecommunications company would not be very productive. Comparisons are only meaningful when they are made for different companies within the same sector.

b)Strength

• It takes into consideration all the assets: There are other ratios which is called fixed asset turnover ratio which only includes fixed asset but in the case of ATR we generally consider all the assets under operation i.e. both fixed and current assets.
• It balances the revenue in sales along with the proportion of assets: This ratio is very useful for companies that are in the growth stage to check if the revenue generated is proportionate to the assets deployed.
• Success/Failure rate of asset: Managers can determine how effective or efficient their asset deployment has been for the company.

c)Weakness

• It includes idle asset too: The ratio includes the entire asset even those which were not deployed in the production or not considered in the specific period where the turnover was generated. Thus this ratio can be incorrect based on the list of the actual asset used an asset which did not contribute at all.
• Individual asset performance: The ratio is the performance of all assets in general. Thus it is not possible to understand or measure how individual asset is performing.
• Profit Calculation: This ratio does not give a clear picture of how good/bad a company is earning its profit.

Fixed Asset Turnover Ratios

Fixed Asset Turnover (FAT) is an efficiency ratio that indicates how well or efficiently a business uses fixed assets to generate sales. This ratio divides net sales by net fixed assets, calculated over an annual period. The net fixed assets include the amount of property, plant, and equipment, less the accumulated depreciation. Generally, a higher fixed asset ratio implies a more effective utilization of investments in fixed assets to generate revenue. This ratio is often analyzed alongside leverage and profitability ratios.

To determine the Fixed Asset Turnover ratio, the following formula is used:

Fixed Asset Turnover = Net Sales / Average Fixed Assets

a)Significance

Generally, a high fixed assets turnover ratio indicates better utilization of fixed assets and a low ratio means inefficient or under-utilization of fixed assets. The usefulness of this ratio can be increased by comparing it with the ratio of other companies, industry standards, and past years.

b)Strength

• Fit for Manufacturing Industry: Bulk of investments is made in the manufacturing industry. Manufacturing concerns buy a lot of plants, equipment, and other fixed assets. Fixed Assets Turnover ratio gives a good edge to manufacturing concerns, a different view in analyzing the return on assets with respect to top-line growth. The high turnover ratio indicates that fixed assets are working efficiently and effectively in generating a good number of sales.
• Makes Comparison easy for investors: Investors analyze this ratio year over year reflecting the efficiency increment or decrement of fixed assets. It also helps them to know when the reinvestments should be made on fixed assets so as to keep in line with growth guidelines.

c)Weakness

• Industry Limitations: It is useful mainly in comparing companies across manufacturing concerns. For asset-light industries like those based heavily on technologies, fixed assets turnover ratio cannot be put to play.
• Does not take Profit into account: The fixed assets turnover ratio only measures the correlation between fixed assets and net sales and not the cause of what impacted the figures. A drop in asset turnover ratio can lead management on useless manhunt chasing for obsolete assets, while in reality, revenue has dropped for an independent reason. Due to such a drawback, the fixed assets turnover ratio should be analyzed over a variety of profit and revenue ratios.

C)Profitability Ratios

Profitability ratios are a class of financial metrics that are used to assess a business's ability to generate earnings relative to its revenue, operating costs, balance sheet assets, and shareholders' equity over time, using data from a specific point in time. Some examples of profitability ratios are profit margin, return on assets (ROA)

Profit Margin

The profit margin is a ratio of a company's profit (sales minus all expenses) divided by its revenue. The profit margin ratio compares profit to sales and tells you how well the company is handling its finances overall. It's always expressed as a percentage.

a)Challenges

The profit margin ratio directly measures what percentage of sales is made up of net income. In other words, it measures how much profits are produced at a certain level of sales. This ratio also indirectly measures how well a company manages its expenses relative to its net sales. That is why companies strive to achieve higher ratios. They can do this by either generating more revenues why keeping expenses constant or keep revenues constant and lower expenses.

b)Strength

• It indicates the cost efficiency of a company and helps track its performance across time periods.
• It helps in assessing the financial health of a company and facilitates peer comparison on that basis.

c)Challenges

• If used to compare companies across different industries or sectors, then the profit margin may lead to meaningless insights.
• It is exposed to the risk of manipulation.

Return on Asset

Return on assets (ROA) is an indicator of how profitable a company is relative to its total assets. ROA gives a manager, investor, or analyst an idea as to how efficient a company's management is at using its assets to generate earnings. Return on assets is displayed as a percentage.ROA is calculated by dividing a company’s net income by total assets

a)Challenges

Return on assets (ROA), in basic terms, tells you what earnings were generated from invested capital (assets). ROA for public companies can vary substantially and will be highly dependent on the industry. This is why when using ROA as a comparative measure, it is best to compare it against a company's previous ROA numbers or against a similar company's ROA. The ROA figure gives investors an idea of how effective the company is in converting the money it invests into net income. The higher the ROA number, the better, because the company is earning more money on less investment. Remember total assets are also the sum of its total liabilities and shareholder's equity. Both of these types of financing are used to fund the operations of the company. Since a company's assets are either funded by debt or equity, some analysts and investors disregard the cost of acquiring the asset by adding back interest expense in the formula for ROA.

b)Strength

• As the metric uses operating income, it effectively captures the influence of both equity and debt financing on asset purchases and its ability to generate profit. So, companies with different capital structures can be compared without any adjustment.
• It helps in assessing the capability of the company’s management in utilizing the available assets.

c)Weakness

• This financial metric is not very useful for companies that belong to capital intensive industries or service-based companies. Capital intensive industries need to invest a significant portion of the profit in regular Capex requirements resulting in low value, while service companies have a minimal investment in assets that result in a very high ROA.
• There is a lack of clarity regarding the numerator used in the ratio. Some companies use operating income, while there are others that use net income. As such, peer comparison among companies with different approaches can be misleading.