10. Analyzing ratios

One of the most important applications of ratio analysis is to compare a companys performance with that of other players in the industry or to compare its own performance over a period of time. Such analyses are referred to as comparative analysis and trend analysis, respectively.

Common size analysis requires the representation of financial statements in relation to a single financial statement item or base.

What is the most commonly used base item for a common size balance sheet in the analysis?

(a)Net income

(b)Total assets

(c)Net sales

(d)Earnings before interest and taxes

Suppose you are conducting an analysis of Green Penguin Ice Companys past three years performance.

Green Penguin did not issue new shares during these three years and has faced some operational difficulties. The company has thus piloted some new forecasting strategies to improve its operations management. You have collected the relevant data, made reasonable assumptions based on the information available, and calculated the following ratios.

Ratios Calculated
	Year 1	Year 2	Year 3
Price to cash flow	6.80	4.76	3.81
Inventory turnover	13.60	10.88	8.70
Debt to equity	0.60	0.48	0.38

Based on the preceding information, your calculations, and your assumptions, which of the following statements can be included in your analysis report? Check all that apply.

(a)A plausible reason why Green Penguins price-to-cash-flow ratio has decreased is that investors expect lower cash flow per share in the future.

(b)A decline in the inventory turnover ratio can be explained by the new inventory management system that the company recently adopted, which led to more efficient inventory management.

(c)A decline in the debt-to-equity ratio implies a decline in the creditworthiness of the firm.

(d)A decline in the inventory turnover ratio could likely be explained by operational difficulties that the company faced, which led to duplicate orders placed to vendors.