Financial Ratio Tutorial

 

Financial Ratio Tutorial

When it comes to investing, analyzing financial statement information (also known as quantitative analysis), is one of, if not the most important element in the fundamental analysis process. At the same time, the massive amount of numbers in a company's financial statements can be bewildering and intimidating to many investors. However, through financial ratio analysis, you will be able to work with these numbers in an organized fashion.

The objective of this tutorial is to provide you with a guide to sources of financial statement data, to highlight and define the most relevant ratios, to show you how to compute them and to explain their meaning as investment evaluators.

In this regard, we draw your attention to the complete set of financials for Zimmer Holdings, Inc. (ZMH), a publicly listed company on the NYSE that designs, manufactures and markets orthopedic and related surgical products, and fracture-management devices worldwide. We've provided these statements in order to be able to make specific reference to the account captions and numbers in Zimmer's financials in order to illustrate how to compute all the ratios.

Among the dozens of financial ratios available, we've chosen 30 measurements that are the most relevant to the investing process and organized them into six main categories as per the following list:

 

Liquidity Measurement Ratios: Introduction

The first ratios we'll take a look at in this tutorial are the liquidity ratios. Liquidity ratios attempt to measure a company's ability to pay off its short-term debt obligations. This is done by comparing a company's most liquid assets (or, those that can be easily converted to cash), its short-term liabilities. 
 
In general, the greater the coverage of liquid assets to short-term liabilities the better as it is a clear signal that a company can pay its debts that are coming due in the near future and still fund its ongoing operations. On the other hand, a company with a low coverage rate should raise a red flag for investors as it may be a sign that the company will have difficulty meeting running its operations, as well as meeting its obligations. 
 
The biggest difference between each ratio is the type of assets used in the calculation. While each ratio includescurrent assets, the more conservative ratios will exclude some current assets as they aren't as easily converted to cash. 
 
The ratios that we'll look at are the current, quick and cash ratios and we will also go over the cash conversion cycle, which goes into how the company turns its inventory into cash.

Liquidity Measurement Ratios: Current Ratio 

The current ratio is a popular financial ratio used to test a company's liquidity (also referred to as its current or working capital position) by deriving the proportion of current assets available to cover current liabilities. 
 
The concept behind this ratio is to ascertain whether a company's short-term assets (cash, cash equivalents, marketable securities, receivables and inventory) are readily available to pay off its short-term liabilities (notes payable, current portion of term debt, payables, accrued expenses and taxes). In theory, the higher the current ratio, the better. 
 
Formula:

 
Components: 

 
As of December 31, 2005, with amounts expressed in millions, Zimmer Holdings' current assets amounted to $1,575.60 (balance sheet), which is the numerator; while current liabilities amounted to $606.90 (balance sheet), which is the denominator. By dividing, the equation gives us a current ratio of 2.6. 
 
Variations:  
None 
 
Commentary: 
The current ratio is used extensively in financial reporting. However, while easy to understand, it can be misleading in both a positive and negative sense - i.e., a high current ratio is not necessarily good, and a low current ratio is not necessarily bad (see chart below). 
 
Here's why: Contrary to popular perception, the ubiquitous current ratio, as an indicator of liquidity, is flawed because it's conceptually based on the liquidation of all of a company's current assets to meet all of its current liabilities. In reality, this is not likely to occur. Investors have to look at a company as a going concern. It's the time it takes to convert a company's working capital assets into cash to pay its current obligations that is the key to its liquidity. In a word, the current ratio can be "misleading." 
 
A simplistic, but accurate, comparison of two companies' current position will illustrate the weakness of relying on the current ratio or a working capital number (current assets minus current liabilities) as a sole indicator of liquidity: 
 

 
Company ABC looks like an easy winner in a liquidity contest. It has an ample margin of current assets over current liabilities, a seemingly good current ratio, and working capital of $300. Company XYZ has no current asset/liability margin of safety, a weak current ratio, and no working capital. 
 
However, to prove the point, what if: (1) both companies' current liabilities have an average payment period of 30 days; (2) Company ABC needs six months (180 days) to collect its account receivables, and its inventory turns over just once a year (365 days); and (3) Company XYZ is paid cash by its customers, and its inventory turns over 24 times a year (every 15 days).  
 
In this contrived example, Company ABC is very illiquid and would not be able to operate under the conditions described. Its bills are coming due faster than its generation of cash. You can't pay bills with working capital; you pay bills with cash! Company's XYZ's seemingly tight current position is, in effect, much more liquid because of its quicker cash conversion.  
 
When looking at the current ratio, it is important that a company's current assets can cover its current liabilities; however, investors should be aware that this is not the whole story on company liquidity. Try to understand the types of current assets the company has and how quickly these can be converted into cash to meet current liabilities. This important perspective can be seen through the cash conversion cycle (read the chapter on CCC now). By digging deeper into the current assets, you will gain a greater understanding of a company's true liquidity. 
 
Liquidity Measurement Ratios: Quick Ratio

 
The quick ratio - aka the quick assets ratio or the acid-test ratio - is a liquidity indicator that further refines the current ratio by measuring the amount of the most liquid current assets there are to cover current liabilities. The quick ratio is more conservative than the current ratio because it excludes inventory and other current assets, which are more difficult to turn into cash. Therefore, a higher ratio means a more liquid current position. 
 
Formula:

 
Components:

 
 

Liquidity Measurement Ratios: Cash Ratio

 
The cash ratio is an indicator of a company's liquidity that further refines both the current ratio and the quick ratio by measuring the amount of cash, cash equivalents or invested funds there are in current assets to cover current liabilities.  
 
Formula:

 
Components:

 

This liquidity metric expresses the length of time (in days) that a company uses to sell inventory, collect receivables and pay its accounts payable. The cash conversion cycle (CCC) measures the number of days a company's cash is tied up in the the production and sales process of its operations and the benefit it gets from payment terms from its creditors. The shorter this cycle, the more liquid the company's working capital position is. The CCC is also known as the "cash" or "operating" cycle. 
 

Liquidity Measurement Ratios: Cash Conversion Cycle 

Formula:

 
Components: 
 
DIO is computed by:

1. Dividing the cost of sales (income statement) by 365 to get a cost of sales per day figure;
2. Calculating the average inventory figure by adding the year's beginning (previous yearend amount) and ending inventory figure (both are in the balance sheet) and dividing by 2 to obtain an average amount of inventory for any given year; and
3. Dividing the average inventory figure by the cost of sales per day figure.

For Zimmer's FY 2005 (in $ millions), its DIO would be computed with these figures:

 
DIO gives a measure of the number of days it takes for the company's inventory to turn over, i.e., to be converted to sales, either as cash or accounts receivable. 
 
DSO is computed by:

1. Dividing net sales (income statement) by 365 to get a net sales per day figure;
2. Calculating the average accounts receivable figure by adding the year's beginning (previous yearend amount) and ending accounts receivable amount (both figures are in the balance sheet) and dividing by 2 to obtain an average amount of accounts receivable for any given year; and
3. Dividing the average accounts receivable figure by the net sales per day figure.

For Zimmer's FY 2005 (in $ millions), its DSO would be computed with these figures:

 

  
DSO gives a measure of the number of days it takes a company to collect on sales that go into accounts receivables (credit purchases). 
 
DPO is computed by:

1. Dividing the cost of sales (income statement) by 365 to get a cost of sales per day figure;
2. Calculating the average accounts payable figure by adding the year's beginning (previous yearend amount) and ending accounts payable amount (both figures are in the balance sheet), and dividing by 2 to get an average accounts payable amount for any given year; and
3. Dividing the average accounts payable figure by the cost of sales per day figure.

For Zimmer's FY 2005 (in $ millions), its DPO would be computed with these figures:

 
DPO gives a measure of how long it takes the company to pay its obligations to suppliers. 
 
CCC computed: 
Zimmer's cash conversion cycle for FY 2005 would be computed with these numbers (rounded):

Variations: 
Often the components of the cash conversion cycle - DIO, DSO and DPO - are expressed in terms of turnover as a times (x) factor. For example, in the case of Zimmer, its days inventory outstanding of 280 days would be expressed as turning over 1.3x annually (365 days ÷ 280 days = 1.3 times). However, actually counting days is more literal and easier to understand when considering how fast assets turn into cash.  
 
Commentary: 
An often-overlooked metric, the cash conversion cycle is vital for two reasons. First, it's an indicator of the company's efficiency in managing its important working capital assets; second, it provides a clear view of a company's ability to pay off its current liabilities.  
 
It does this by looking at how quickly the company turns its inventory into sales, and its sales into cash, which is then used to pay its suppliers for goods and services. Again, while the quick and current ratios are more often mentioned in financial reporting, investors would be well advised to measure true liquidity by paying attention to a company's cash conversion cycle.  
 
The longer the duration of inventory on hand and of the collection of receivables, coupled with a shorter duration for payments to a company's suppliers, means that cash is being tied up in inventory and receivables and used more quickly in paying off trade payables. If this circumstance becomes a trend, it will reduce, or squeeze, a company's cash availabilities. Conversely, a positive trend in the cash conversion cycle will add to a company's liquidity. 
 
By tracking the individual components of the CCC (as well as the CCC as a whole), an investor is able to discern positive and negative trends in a company's all-important working capital assets and liabilities.  
 
For example, an increasing trend in DIO could mean decreasing demand for a company's products. Decreasing DSO could indicate an increasingly competitive product, which allows a company to tighten its buyers' payment terms.  
 
As a whole, a shorter CCC means greater liquidity, which translates into less of a need to borrow, more opportunity to realize price discounts with cash purchases for raw materials, and an increased capacity to fund the expansion of the business into new product lines and markets. Conversely, a longer CCC increases a company's cash needs and negates all the positive liquidity qualities just mentioned. 
 
Note: In the realm of free or low-cost investment research websites, the only one we've found that provides complete CCC data for stocks is Morningstar, which also requires a paid premier membership subscription.  
 
Current Ratio Vs. The CCC 
The obvious limitations of the current ratio as an indicator of true liquidity clearly establish a strong case for greater recognition, and use, of the cash conversion cycle in any analysis of a company's working capital position. 
 
Nevertheless, corporate financial reporting, investment literature and investment research services seem to be stuck on using the current ratio as an indicator of liquidity. This circumstance is similar to the financial media's and the general public's attachment to the Dow Jones Industrial Average. Most investment professionals see this index as unrepresentative of the stock market or the national economy. And yet, the popular Dow marches on as the market indicator of choice. 
 
The current ratio seems to occupy a similar position with the investment community regarding financial ratios that measure liquidity. However, it will probably work better for investors to pay more attention to the cash-cycle concept as a more accurate and meaningful measurement of a company's liquidity.