Critical Ratio Analysis


This memorandum analyzes Company G at the end of year 12 by explaining 13 applicable ratios derived from the comparative income statements and balance sheets from years 11 and 12 and comparing the data to corresponding industry quartiles.

Current Ratio

Current Ratio measures the company’s capacity to pay its short-term liabilities. This ratio derives from dividing total current assets by total current liabilities. A higher ratio is preferable. For year 12, the current ratio is 1.79. This is a decline from last year’s ratio of 1.86. When compared with industry quartiles this ratio falls below the median of 2.1 but above the lower quartile of 1.4. This ratio indicates a weakness.

Acid-test Ratio

The Acid-Test measures the company’s ability to pay current liabilities if they were all due immediately.  This is found by adding cash, short-term investments and net current receivables and dividing the result by total current liabilities. This ratio should be around 1.0. This year it is 0.43. This is a drop from the year 11 ratio of 0.64 and falls below the lowest quartile of 0.6. This also indicates a weakness in the company.

Inventory Turnover

Inventory Turnover rate indicates how many times per year inventory is sold and replaced. Higher rates are preferable as the faster inventory is moving indicates how profitably the company is operating. This rate is found by taking the cost of goods sold and dividing it by the average of the beginning and ending inventory from the cycle. In this case, the ratio is 5.17. This is another drop from year 11, which saw a rate of 6.1. Both of these rates fall below the lowest industry quartile of 8.3. This also signifies a weakness.

Accounts Receivable Turnover

This ratio is a measure of the company’s success in collecting from credit customers. The formula is to divide net credit sales by the beginning and ending average of net accounts receivable. This ratio is better high. For year 12, it is 30.46. This is a drop from last year’s ratio of 32.2. This year’s drop puts the company below the lowest quartile of 31.4. This ratio is also a weakness.

Day’s Sales in Receivables

Day’s sales show how many days a balance is carried in receivables. This is calculated in two steps. First, net credit sales are divided by 365 to arrive at an average daily credit sale. Next, the average of beginning and ending net accounts receivable is divided by the average daily credit sales.  A lower number is better. For year 12, this ratio is 11.98. This is up slightly from year 11 that had 11.1. This places the company above the median of 13.5 but below the upper quartile of 11.3. While there was a drop from last year, collections for the company are not a concern.

Debt Ratio

This ratio reveals a company’s ability to pay all of its debts. This number is found by dividing total liabilities by total assets. A lower debt ratio is preferable and is currently 29.54%. This is a slight increase from last year’s ratio of 28.34%. Even still, it is above the 30% threshold of the upper quartile. This is definitely a strength.

Times-interest-earned Ratio

Also called the interest-coverage ratio, this shows how many times operating income can pay interest expenses. To find this ratio, divide operating income by interest expense. The higher the result the better and the company looks good here with a 35.55 at the end of year 12. Last year’s ratio was 31.12 and both ratios are above the 29.7 level of the upper quartile. This is a strength.

Rate of Return on Net Sales

This shows the percentage of sales that result in profit. It is found by dividing net income by net sales. For year 12, this is 6.21%, up from last year’s 5.43%. This year’s number places Company G above the median quartile of 6.12% but below the upper quartile of 7.55%. The ratio is increasing and is above the industry median so there is no concern.

Rate of Return on Total Assets

This ratio measures profitability for creditors and shareholders. To compute, the sum of net income and interest expense is divided by the average total assets from the beginning and ending of the period to arrive at a percentage.  Again, a higher ratio is better. This year’s rate is 13.92%, up from last year’s 12.3%. This year moves the company above the median of 12.3% but below the upper quartile of 17.2%. For the same reasons as return on sales, this is no concern.

Rate of Return on Common Stockholders’ Equity

This ratio narrows the profitability measure specifically to common stockholders. Often called return on equity, it shows how much profit stockholders made. It is calculated by subtracting preferred dividends (which for Company G is zero) from net income, then dividing this number by the average of stockholders equity at the beginning and end of the period. This year saw a drop in this ratio to 18.75% from 20.2% a year ago. As this year’s ratio is still within the upper quartile above 18.6%, this return is a strength.

Earnings per Share of Common Stock

EPS, the common acronym for this ratio, shows the amount earned by each share of common stock. To begin computing the ratio, treasury stock held by the company is subtracted from issued stock to arrive at the number of shares outstanding. Net income (with preferred dividends subtracted, if applicable) is then divided by this number. A higher EPS is better. In this case, it is $1.05 for year 12, up from $0.67 in year 11. This is well above the upper quartile boundary of $0.90 and is a strength.

Price/Earnings Ratio

The next ratio develops the EPS to show what the market value is relative to each dollar of EPS. It is found by dividing the market price of a share of common stock by the EPS. A higher number is better. The result for this period was $5.48. For year 11, it was $5.21. It has gone up but the total still places in the bottom quartile below $5.50, making it a weakness.

Book Value per Share of Common Stock

This ratio is a measure of stockholders equity from the balance sheet. It is found by taking total stockholder equity (minus preferred equity, if there were any) and dividing by the number of shares of common stock outstanding. A higher value is better again. The value for year 12 is $5.89. For year 11 it was $4.25. Compared to the industry quartiles it is above the median of $5.50 and below the upper quartile of $6.00. This is no concern.


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