Ratios facilitate time-series and cross-sectional analysis of a company’s financial position. Balance sheet ratios are those involving balance sheet items only. Each of the line items on a vertical common-size balance sheet is a ratio in that it expresses a balance sheet amount in relation to total assets. Other balance sheet ratios compare one balance sheet item to another. For example, the current ratio expresses current assets in relation to current liabilities as an indicator of a company’s liquidity. Balance sheet ratios include liquidity ratios (measuring the company’s ability to meet its short-term obligations) and solvency ratios (measuring the company’s ability to meet long-term and other obligations). These ratios and others are discussed in a later reading. Exhibit 13 summarizes the calculation and interpretation of selected balance sheet ratios.
Exhibit 13: Balance Sheet Ratios
Liquidity Ratios Calculation Indicates
Current Current assets ÷ Current
liabilities Ability to meet current liabilities Quick (acid test) (Cash + Marketable securi-
ties + Receivables) ÷ Current liabilities
Ability to meet current liabilities
Cash (Cash + Marketable securi-
ties) ÷ Current liabilities Ability to meet current liabilities
Solvency Ratios
Long-term debt-to-equity Total long-term debt ÷ Total
equity Financial risk and financial leverage
Debt-to-equity Total debt ÷ Total equity Financial risk and financial leverage
Total debt Total debt ÷ Total assets Financial risk and financial leverage
Financial leverage Total assets ÷ Total equity Financial risk and financial leverage
RATIO ANALYSIS
1. Based on its balance sheet presented earlier, the current ratio for SAP Group at 31 December 2017 is closest to:
A. 1.17.
B. 1.20.
C. 2.00.
Solution:
A is correct. SAP Group’s current ratio (Current assets ÷ Current liabilities) at 31 December 2017 is 1.17 (EUR11,930 million ÷ EUR10,210 million).
2. Based on SAP’s balance sheets presented earlier, which of the following liquidity ratios decreased in 2017 relative to 2016? (Note: More than one answer may be correct.)
A. Cash
B. Quick C. Current Solution:
A, B, and C are correct. The cash ratio, quick ratio, and current ratio are lower in 2017 than in 2016.
Liquidity Ratios Calculation 2017 EUR in millions 2016 EUR in millions Current Current assets ÷ Current
liabilities EUR11,930 ÷ EUR10,210
= 1.17 EUR11,564 ÷ EUR9,674
= 1.20 Quick (acid test)* (Cash + Marketable securi-
ties + Receivables) ÷ Current liabilities
(EUR4,011 + EUR990 + EUR5,899) ÷ EUR10,210 = 1.07
(EUR3,702 + EUR1,124 + EUR5,924)
÷ EUR9,674 = 1.11
Cash* (Cash + Marketable securi-
ties) ÷ Current liabilities (EUR4,011 + EUR990 ÷ EUR10,210
= 0.49
(EUR3,702 + EUR1,124 ÷ EUR9,674 = 0.50
* Marketable securities is assumed to be equal to Other Financial Assets as shown in Exhibit 6.
3. Based on SAP’s balance sheets presented earlier, which of the following leverage ratios decreased in 2017 relative to 2016? (Note: more than one answer may be correct.)
A. Debt-to-equity.
B. Financial leverage.
C. Long-term debt-to-equity.
Solution:
A, B, and C are correct. All three leverage ratios decreased in 2017 relative to 2016.
Solvency Ratios Long-term
debt-to-equity Total long-term debt ÷ Total
equity EUR5,034 ÷ EUR25,540
= 19.7% EUR6,481 ÷ EUR26,397
= 24.6%
Debt-to-equity Total debt ÷ Total equity (EUR1,561 + EUR5,034) ÷ EUR25,540
= 25.8%
(EUR 1,813 + EUR6,481) ÷ EUR26,397
= 31.4%
Financial Leverage Total assets ÷ Total equity EUR42,497 ÷ EUR25,540
= 1.66 EUR44,277 ÷ EUR26,397
= 1.68 Cross-sectional financial ratio analysis can be limited by differences in accounting methods. In addition, lack of homogeneity of a company’s operating activities can limit comparability. For diversified companies operating in different industries, using industry-specific ratios for different lines of business can provide better comparisons.
Companies disclose information on operating segments. The financial position and performance of the operating segments can be compared to the relevant industry.
Ratio analysis requires a significant amount of judgment. One key area requiring judgment is understanding the limitations of any ratio. The current ratio, for exam- ple, is only a rough measure of liquidity at a specific point in time. The ratio cap- tures only the amount of current assets, but the components of current assets differ significantly in their nearness to cash (e.g., marketable securities versus inventory).
Another limitation of the current ratio is its sensitivity to end-of-period financing and operating decisions that potentially can affect current asset and current liability amounts. Another overall area requiring judgment is determining whether a ratio for a company is within a reasonable range for an industry. Yet another area requiring judgment is evaluating whether a ratio signifies a persistent condition or reflects only a temporary condition. Overall, evaluating specific ratios requires an examination of the entire operations of a company, its competitors, and the external economic and industry setting in which it is operating.
PRACTICE PROBLEMS
1. All of the following are current assets except:
A. cash.
B. goodwill.
C. inventories.
2. The initial measurement of goodwill is most likely affected by:
A. an acquisition’s purchase price.
B. the acquired company’s book value.
C. the fair value of the acquirer’s assets and liabilities.
3. For financial assets classified as trading securities, how are unrealized gains and losses reflected in shareholders’ equity?
A. They are not recognized.
B. They flow through income into retained earnings.
C. They are a component of accumulated other comprehensive income.
4. For financial assets classified as available for sale, how are unrealized gains and losses reflected in shareholders’ equity?
A. They are not recognized.
B. They flow through retained earnings.
C. They are a component of accumulated other comprehensive income.
5. For financial assets classified as held to maturity, how are unrealized gains and losses reflected in shareholders’ equity?
A. They are not recognized.
B. They flow through retained earnings.
C. They are a component of accumulated other comprehensive income.
6. A company has total liabilities of GBP35 million and total stockholders’ equity of GBP55 million. Total liabilities are represented on a vertical common-size balance sheet by a percentage closest to:
A. 35 percent.
B. 39 percent.
C. 64 percent.
7. Which of the following would an analyst most likely be able to determine from a common-size analysis of a company’s balance sheet over several periods?
A. An increase or decrease in sales
B. An increase or decrease in financial leverage C. A more efficient or less efficient use of assets
8. Defining total asset turnover as revenue divided by average total assets, all else equal, impairment write-downs of long-lived assets owned by a company will most likely result in an increase for that company in:
A. the debt-to-equity ratio but not the total asset turnover.
B. the total asset turnover but not the debt-to-equity ratio.
C. both the debt-to-equity ratio and the total asset turnover.
9. An investor concerned about a company’s ability to meet its near-term obliga- tions is most likely to calculate the:
A. current ratio.
B. return on total capital.
C. financial leverage ratio.
10. The most stringent test of a company’s liquidity is its:
A. cash ratio.
B. quick ratio.
C. current ratio.
11. An investor worried about a company’s long-term solvency would most likely examine its:
A. current ratio.
B. return on equity.
C. debt-to-equity ratio.
12. Consider the common-size balance sheets in Exhibit 1 for Company A, Company B, as well as the industry average. Which statement is correct?
Exhibit 1: Balance Sheet and Industry Average
Company
A Company
B Industry
Average ASSETS
Current assets
Cash and cash equivalents 5 5 7
Marketable securities 5 0 2
Accounts receivable, net 5 15 12
Inventories 15 20 16
Prepaid expenses 5 15 11
Total current assets 35 55 48
Company
A Company
B Industry
Average
Property, plant, and equipment,
net 40 35 37
Goodwill 25 0 8
Other assets 0 10 7
Total assets 100 100 100
LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities
Accounts payable 10 10 10
Short-term debt 25 10 15
Accrued expenses 0 5 3
Total current liabilities 35 25 28
Long-term debt 45 20 28
Other non-current liabilities 0 10 7
Total liabilities 80 55 63
Total shareholders’ equity 20 45 37
Total liabilities and shareholders’
equity 100 100 100
A. Company A has below-average liquidity risk.
B. Company B has above-average solvency risk.
C. Company A has made one or more acquisitions.
13. The quick ratio for Company A is closest to:
A. 0.43.
B. 0.57.
C. 1.00.
14. The financial leverage ratio for Company B is closest to:
A. 0.55.
B. 1.22.
C. 2.22.
15. Which ratio indicates lower liquidity risk for Company A compared with Compa- ny B?
A. Cash ratio B. Quick ratio C. Current ratio
SOLUTIONS
1. B is correct. Goodwill is a long-term asset, and cash and inventories are current assets.
2. A is correct. Initially, goodwill is measured as the difference between the pur- chase price paid for an acquisition and the fair value of the acquired, not acquir- ing, company’s net assets (identifiable assets less liabilities).
3. B is correct. For financial assets classified as trading securities, unrealized gains and losses are reported on the income statement and flow to shareholders’ equity as part of retained earnings.
4. C is correct. For financial assets classified as available for sale, unrealized gains and losses are not recorded on the income statement and instead are part of other comprehensive income. Accumulated other comprehensive income is a compo- nent of shareholders’ equity.
5. A is correct. Financial assets classified as held to maturity are measured at amor- tized cost. Gains and losses are recognized only when realized.
6. B is correct. Vertical common-size analysis involves stating each balance sheet item as a percentage of total assets. Total assets are the sum of total liabilities (GBP35 million) and total stockholders’ equity (GBP55 million), or GBP90 million. Total liabilities are shown on a vertical common-size balance sheet as (GBP35 million ÷ GBP90 million) ≈ 39%.
7. B is correct. A common-size balance sheet analysis provides information about the composition of the balance sheet and it changes over time. As a result, it can provide information about an increase or decrease in a company’s financial leverage.
8. C is correct. Impairment write-downs reduce equity in the denominator of the debt-to-equity ratio but do not affect debt, so the debt-to-equity ratio is expected to increase. Impairment write-downs reduce total assets but do not affect reve- nue. Thus, total asset turnover is expected to increase.
9. A is correct. The current ratio provides a comparison of assets that can be turned into cash relatively quickly and liabilities that must be paid within one year. The other ratios are more suited to evaluate longer-term concerns.
10. A is correct. The cash ratio determines how much of a company’s near-term obli- gations can be settled with existing amounts of cash and marketable securities.
11. C is correct. The debt-to-equity ratio, a solvency ratio, is an indicator of financial risk.
12. C is correct. The presence of goodwill on Company A’s balance sheet signifies that it has made one or more acquisitions in the past. The current, cash, and quick ratios are lower for Company A than for the sector average. These low- er liquidity ratios imply above-average liquidity risk. The total debt, long-term debt-to-equity, debt-to-equity, and financial leverage ratios are lower for Compa- ny B than for the sector average. These lower solvency ratios imply below-average solvency risk.
Current ratio is (35 ÷ 35) = 1.00 for Company A, versus (48 ÷ 28)
= 1.71 for the sector average.
Cash ratio is (5 + 5) ÷35 = 0.29 for Company A, versus (7 + 2) ÷28 = 0.32 for the sector average.
Quick ratio is (5 + 5 + 5) ÷35 = 0.43 for Company A, versus (7 + 2 + 12) ÷28 = 0.75 for the sector average.
Total debt ratio is (55 ÷ 100) = 0.55 for Company B, versus (63 ÷ 100) = 0.63 for the sector average.
Long-term debt-to-equity ratio is (20 ÷ 45) = 0.44 for Company B, versus (28 ÷ 37)
= 0.76 for the sector average.
Debt-to-equity ratio is (55 ÷ 45) = 1.22 for Company B, versus (63 ÷ 37) = 1.70 for the sector average.
Financial leverage ratio is (100 ÷ 45) = 2.22 for Company B, versus (100 ÷ 37) = 2.70 for the sector average.
13. A is correct. The quick ratio is defined as (Cash and cash equivalents + Market- able securities + receivables) ÷ Current liabilities. For Company A, this calcula- tion is (5 + 5 + 5) ÷ 35 = 0.43.
14. C is correct. The financial leverage ratio is defined as Total assets ÷ Total equity.
For Company B, total assets are 100 and total equity is 45; hence, the financial leverage ratio is 100 ÷ 45 = 2.22.
15. A is correct. A higher cash ratio reflects lower liquidity risk. The cash ratio is defined as (Cash + Marketable securities) ÷ Current liabilities. Company A’s cash ratio, (5 + 5) ÷ 35 = 0.29, is higher than (5 + 0) ÷ 25 = 0.20 for Company B.