Ratio analysis is an important way of evaluating financial statements. Using ratios, instead of simply raw financial data, can help to make better comparisons of the strength of companies. There are many different kinds of ratios, which can be grouped into five general categories: 1. Liquidity ratios: These ratios are used to analyze whether or not a firm is able to pay its short-term debts (typically maturing within the next year). Good liquidity ratios are needed to continue operations of the firm. 2. Asset management ratios: These ratios are used to analyze the efficiency of asset use by a firm. Reasonable asset management ratios are required to sustain acceptable levels of net income. 3. Debt management ratios: These ratios analyze how a firm has financed its assets, as well as whether or not the firm can repay its long-term debt. 4. Profitability ratios: These ratios analyze how profitable a firm is. These ratios take both asset and debt management ratios into account to analyze overall return on equity. 5. Market value ratios: These ratios analyze investor confidence in the firm, both now and into the future. Suppose one firm has borrowed significant funds and bankruptcy appear imminent, while another firm has not borrowed very much cash and has very little chance of bankruptcy. Which of the following categories of ratios would likely be most appropriate for comparing these companies in this scenario? Inventory turnover ratios Asset management ratios Market value ratios Debt management ratios Step 2: Learn: Ratio Analysis Ratio analysis involves calculations using data from a companys financial statements. Watch the following video for an example, then answer the questions that follow. Suppose that you are given the following data for Niles Company : Note: The data and calculations are based on a 365day year. Cash and equivalents $562,500 Fixed assets $1,625,000 Sales $6,250,000 Net income $281,250 Current liabilities $600,000 Current ratio 2.5 DSO 18.25 ROE 12.00% The current ratio is equal to . Plugging in the relevant values for the current ratio and current liabilities, and then solving yields a current assets value of . Adding fixed assets to current assets yields a value of total assets of . The days sales outstanding (DSO) ratio is equal to . Plugging in the relevant values for the DSO ratio and sales, and then solving yields an accounts receivable balance of . Return on equity (ROE) is to . Plugging in the relevant values for ROE and net income yields a value of total common equity of approximately . Recall that Total Assets=Total Liabilities and Equity . Mathematically, total liabilities and equity is equal to . Plugging in the relevant values for total liabilities and equity, current liabilities, and equity (calculated using the previous identify) and then solving for long-term debt, yields a long-term debt of . Return on assets (ROA) is equal to the product of profit margin multiplied by total assets turnover, which is equivalent to . Plugging in the relevant values for net income and total assets yields an ROA of approximately . Recall the following identity: Current Assets=Cash and equivalents+Accounts Receivable+Inventories The quick ratio is equal to . Plugging in the relevant values for current assets, current liabilities, and inventories (calculated using the previous identity) yields a quick ratio of approximately . Suppose that Niles could reduce its DSO from 18.25 to 12. Given the formula for DSO from the video, as well as the same annual sales of $6,250,000, the new value accounts receivable (associated with the new DSO) must be , all else equal. The change (or the absolute value of the difference between the original and new values) in accounts receivable represents an amount of approximately in cash generated. As a result of the stock buy back, the ROA and ROE both . Suppose Niles uses the cash generated by the lower DSO to buy back common stock at book value, thus reducing common equity. As a result of this new, lower, DSO, total debt and total capital . This means that the total debt/total capital ratio must . Step 3: Practice: Ratio analysis Now its time for you to practice what youve learned. Suppose that you are given the following data for Niles Company: Note: The data and calculations are based on a 365day year. Cash and equivalents $787,500 Fixed assets $2,275,000 Sales $8,750,000 Net income $393,750 Current liabilities $840,000 Current ratio 2.5 DSO 18.25 ROE 12.00% Fill in the table with the appropriate values. (Hint: Use the formulas you learned in the video and exercises in the previous stage of the problem.) Accounts receivable $ Current assets $ Total assets $ Fill in the table with the appropriate values. (Hint: Use the formulas you learned in the video and exercises in the previous stage of the problem.) Hint: Recall that Current Assets=Cash and Equivalents+Accounts Receivable+Inventories . ROA Common equity $ Quick ratio Hint: Recall that Total Liabilities and Equity=Total Assets . Long term debt is . Suppose that Niles could reduce its DSO from 18.25 to 12, and use the cash that was generated to buy back common stock at book value. Use the table to indicate the change in accounts receivable, ROA, ROE, and total debt/total capital ratio. Increase Decrease Does not change Accounts receivable ROA ROE Total debt/total capital ratio