## Ratio Calculations and Trend Analysis

Part 2 - Trend Analysis

In part 1, you learned how to calculate ratios that assist in measuring a company's liquidity, leverage, activity, and profitability. These ratios have been calculated for The Widget Company for 200Y only. Moreover, these ratios provide us with a great deal of information on the company's performance for 200Y, but tell us nothing about the company's performance prior to 200Y. Therefore, to gain a greater insight into The Widget Manufacturing Company, a trend analysis must be developed. A trend analysis looks at a company's performance over time (not just one year) and indicates whether a company is improving or declining in performance.

A trend analysis requires a business owner to calculate ratios over many business years. An existing entrepreneur, in business for four (4) years, for example, would use each year's Balance Sheet and Income Statement to calculate four sets of ratios; one set for each business year. By comparing previous year's ratios to the current year ratios, the entrepreneur can determine which areas of his/her business has improved or faltered. An aspiring entrepreneur, on the other hand, planning on establishing a business, would use their three annual forecasted balance sheets and forecasted income statements to calculate three sets of ratios - one set of ratios for each forecasted business year. This will show investors and the aspiring entrepreneur whether the planned business venture intends to improve in performance or decline in performance during the three year forecasted period.

To illustrate a trend analysis, assume the Widget Manufacturing Company has been in business since January 1, 200X. The company's balance sheet and income statement for the business years ending December 31, 200X and 200Y are as follows.

 Widget Manufacturing CompanyBalance Sheet As of December 31, 200X, 200Y 200X 200Y ASSETS: Current Assets: Cash \$ 4,000 \$ 2,550 Marketable Securities \$ 0 \$ 2,000 Account Receivable (Net) \$13,850 \$16,675 Inventories \$22,500 \$26,470 Total Current Assets \$40,350 \$47,695 Fixed Assets Plant & Equipment \$35,700 \$41,000 Less: Accumulated Depreciation \$ 5,200 \$11,000 Net Plant & Equipment \$30,500 \$30,000 TOTAL ASSETS \$70,850 \$77,695 LIABILITIES: Current Liabilities: Accounts Payable \$ 4,400 \$ 9,500 Short-term Bank Loan \$14,000 \$11,375 Total Current Liabilities \$18,400 \$20,875 Total Long Term Debt \$28,977 \$24,000 TOTAL LIABILITIES \$47,377 \$44,875 EQUITY: Common Shares \$20,000 \$25,000 Retained Earnings \$ 3,473 \$ 7,820 TOTAL EQUITY \$23,473 \$32,820 TOTAL LIABILITIES & EQUITY \$70,850 \$77,695

 Widget Manufacturing Company Condensed Income Statement For Years Ending December 31, 200X, 200Y 200X 200Y Net Sales \$105,000 \$112,500 Cost of Goods Sold(COGS) \$ 84,000 \$ 85,040 Gross Margin \$ 21,000 \$ 27,460 Operating Expenses \$ 14,350 \$ 18,950 Net Income Before Taxes \$ 6,650 \$ 8,510 Less: Taxes \$ 3,177 \$ 4,163 Net Income After Taxes \$ 3,473 \$ 4,347

- No Dividends were declared or paid to shareholders during 200X or 200Y

- Average inventory is calculated by adding the beginning & ending inventories together and dividing the sum by 2. Beginning inventory on January 1, 200X, was ZERO (first day of operations). The beginning inventory for 200Y is the ending inventory for the 200X business year (IE Beginning Inventory as of January 1, 200Y was \$22,500) .

Now we have all the information needed to calculate the following ratios for The Widget Company (200X and 200Y).

 Current Ratio Debt-to-Equity Ratio Quick Ratio Gross Profit Margin Average collection Period Net Profit Margin Inventory Turnover Return on Total Assets Debt Ratio Return on Equity

Current Ratio

The current ratio measures whether a company has the ability to use its current assets to pay its short-term creditors (current liabilities). Financial Analysts deem a 2 to 1 ratio as an acceptable current ratio. The Widget Manufacturing Company's current ratios for 200X and 200Y are calculated below.

 200X 200Y Current Assets Current Liabilities \$40,350 \$18,400 \$47,695 \$20,875 = 2.19 = 2.28

In 200X, the company's current assets exceeded its current liabilities by 2.19 times. In 200Y, the company's current assets exceeded its current liabilities by 2.28 times. In both years, the company has the ability to use it current assets (resources) to pay for its short-term debt (current liabilities).

Current Ratio Trend:
The current ratio has increased from 200X to 200Y. This means the company is becoming stronger and has more current assets in relation to its current liabilities.

Quick Ratio

The quick ratio measures whether a company has the ability to use its current assets (without selling inventory) to pay its short-term creditors. Investors like to see a high quick ratio, since it shows the venture does not have to rely heavily on selling its inventory in order to pay its short-term debt. The Widget Manufacturing Company's quick ratios for 200X and 200Y are calculated below.

 200X 200Y Current Assets - Inventories Current Liabilities \$40,350 - \$22,500 \$18,400 \$47,695 - \$26,470 \$20,875 0.97 1.02

In 200X, the company's current assets (excluding inventory) are equal to 97% of its current liabilities. Many business students cannot comprehend the above percentage analogy, rather they rely on a dollar analogy. The dollar analogy states, "for every one dollar the company owes, it has 97 cents in current assets (excluding inventory).

In 200Y, the company's current assets (excluding inventory) are equal to 102% of its current liabilities. Or for every \$1.00 the company owes, it has \$1.02 in current assets (excluding inventory).

Quick Ratio Trend:
The quick ratio has increased from 200X to 200Y. This means the company is becoming stronger and has more current assets (excluding inventory) in relation to its current liabilities. Therefore, its ability to pay short-term creditors has improved.

Average Collection Period

The average collection period ratio determines the number of days, on average, it takes for a company to receive payment from customers who buy products on credit. Financial Analysts suggest the average collection period should not extend beyond the company's credit granting policy (30, 60, 90, or 120 days). The Widget Manufacturing Company's average collection period ratios for 200X and 200Y are calculated below.

 200X 200Y Accounts Receivable x 360 days Sales \$13,850 x 360 \$105,000 \$ 16,675 x 360 \$112,500 = 47.5 or 48 days = 53.35 days or 54 days

As you can see, the 200X average collection period is 48 days. This means, the company's customers, on average, will wait 48 days before paying for products they purchase on credit. In 200Y, the company's customers waited an extra 6 days to pay for purchases place on credit (54 days - 48 days).

Average Collection Period Ratio Trend:
The average collection period ratio has increased from 200X to 200Y. This means the company is financing the products they sell longer, and as a result, the company's cash flow and interest charges are higher. If the company "grants" its customers 60 days to pay for purchases placed on credit, then both ratios (47 days or 54 days) are acceptable. If, on the other hand, the company allows its customers only 30 days to pay for purchases placed on credit, then management is not collecting the accounts receivable efficiently enough. In this case, management should attempt to reduce the average collection period by screening customers more carefully or by implementing new collection strategies & policies.

Inventory Turnover

The inventory Turnover ratio provides an indication on whether a company has an excessive or inadequate amount of product in inventory. The ratio will determine the number of times per year a company uses or consumes an average stock of inventory. The Widget Manufacturing Company's inventory turnover ratios for 200X and 200Y are calculated below.

 200X 200Y Cost of Goods Sold Average Inventory \$ 84,000 (\$0 + 22,500) / 2 \$ 85,040 (\$22,500 + \$26,470) / 2 = 3.7 times = 3.5 times

As you can see, the company's inventory turnover ratios are 3.7 and 3.5 for 200X and 200Y respectively. This means the company "used up" its inventory 3.7 times during 200X and "used up" its inventory 3.5 times during 200Y. In other words, the company has more money tied up in financing its inventory in 200Y than it had in 200X. Furthermore, the company did not sell off its inventory as fast in 200Y as it did in 200X. The Widget Manufacturing Company must re-evaluate its inventory management policy.

Debt Ratio

The debt ratio measures the extent to which borrowed money has been used to finance a company's operation. Investors like to see a low debt ratio, since it shows a company is relying less on creditors (such as banks, suppliers, etc) to finance its operation. The Widget Manufacturing Company's debt ratios for 200X and 200Y are calculated below.

 200X 200Y Total Debt Total Assets \$47,377 \$70,850 \$44,875 \$77,695 = 0.67 = 0.58

The debt ratio for 200X is 0.67 or in other words, 67% of the company's assets are financed by creditors. From a dollar point of view, for every one dollar the company has in assets, it has 67 cents in debt. In 200Y, the debt ratio is .58. This means, 58% of the company's assets are financed by creditors. Or, for every one dollar the company has in assets, it has 58 cents in debt.

Debt Ratio Trend:
As indicated above, the company's debt ratio is declining. Therefore, the company is paying off its creditors and thus, owes less money to them. This is an indication that the company is becoming stronger, and closer to "self sufficiency".

Debt-to-Equity

The debt-to-equity ratio compares the investments made by creditors to the investments made by the company's owners or shareholders. Investors like to see a low debt-to-equity ratio, since it indicates owner's investments into the company are higher than creditor's investments into the company. The Widget Manufacturing Company's debt-to-equity ratios for 200X and 200Y are calculated below.

 200X 200Y Total Debt Total Equity \$47,377 \$23,473 \$44,875 \$32,820 = 2.01 = 1.37

The debt-to-equity ratio for 200X is 2.01 . Furthermore, for every one dollar the owners have invested into the company, creditors invested \$2.01. In 200Y, the debt-to-equity ratio is 1.37 . That is, for every \$1.00 invested by the company's owners, investors such as banks invested (loaned) \$1.37

Debt-to-Equity Ratio Trend:

As you can see, the company's debt-to-equity ratio is declining. In other words, the company shareholders own more of the company in 200Y then they owned in 200X. Creditors, however, still "own" (contributed more to) more of the company in 200Y then the owners. At any rate, the company is paying its debt and therefore, owe less money to creditors in 200Y. This is an indication that the company is becoming somewhat stronger, but as you'll see in PART 3, the company still owes too much money to its creditors and therefore, these debt-to-equity ratios are not deemed acceptable.

Gross Profit Margin

The gross profit margin ratio provides an indication on how well a company is setting its prices and controlling its production costs. Investors like to see a high gross profit margin since it indicates the enterprise is generating more money from each sale. The Widget Manufacturing Company's gross profit margin ratios for 200X and 200Y are calculated below.

 200X 200Y Sales - Cost of goods sold Sales \$105,000 - \$84,000 \$105,000 \$112,500 - \$ 85,040 \$112,500 = 0.20 = 0.24

As you can see, the 200X gross margin is .20 or 20%. This means, for every one dollar (\$1.00) generated in sales, 20 cents remain in the company to pay for its operating expenses income taxes, dividends, etc.... If we were to assume, all products sold by the company sell for \$1.00, then in 200X the company made 20 cents from each sale.

In 200Y, the company gross profit margin is .24 or 24%. This means, for every one dollar (\$1.00) generated in sales, 24 cents remain in the company to pay for its operating expenses income taxes, dividends, etc... If we assume that all products sold by the company has a selling price of \$1.00, then in 200Y the company made 24 cents from each sale.

Gross Profit Trend:
The gross profit margin has increased by 4 cents over 200X. This means the company's management team is improving its price setting policies, and/or reducing the company's production costs, or a combination of both. At any rate, a higher gross profit margin indicates the company is making more from each sale.

Net Profit Margin

The Net Profit Margin ratio assists a company in determining whether their selling prices are too low or if expenses are too high or both. Investors like to see high net profit margins since it provides an indication of how well management's is setting its prices and controlling both production costs and operating expenses. The Widget Manufacturing Company's net profit margin ratios for 200X and 200Y are calculated below.

 200X 200Y Net income after taxes Sales \$ 3,473 \$105,000 \$ 4,347 \$112,500 = 0.03 = 0.04

As you can see, the 200X net profit margin is 0.03 or 3%. This means, for every one dollar (\$1.00) generated in sales, 3 cents remain in the company or is available to be distributed to the owners of the company or both. If we were to assume, all products sold by the company had a selling price of \$1.00, then 3 cents from each sale contributed to the company's net income.

In 200Y, the company net profit margin is 0.04 or 4%. This means, for every one dollar (\$1.00) generated in sales, 4 cents remain in the company or is available to be distributed to the owners of the company or both. If we assume that all products sold by the company had a selling price of \$1.00, then we can conclude that 4 cents from every sale "contributed" to their net income.

Net Profit Trend:
The net profit margin has increased by 1 cent from 200X. This means the company's management team is improving its price setting policies and/or reducing their production costs and operating expenses. At any rate, a higher net profit margin indicates the company is becoming stronger.

Return on Total Assets

The Return on Total Assets ratio measures how well a company is using its assets to generate after tax profits (net income after taxes). Investors like to see a high return on total assets since it indicates a company is using its assets efficiently to generate after tax profits. The Widget Manufacturing Company's return on total assets ratios for 200X and 200Y are calculated below.

 200X 200Y Net income after taxes Total assets \$ 3,473 \$70,850 \$ 4,347 \$77,695 = 0.05 = 0.06

As you can see, the company's 200X return on total assets is 0.05 or 5%. This means, for every one dollar (\$1.00) spent on purchasing assets, the company generated 5 cents in after tax profits. The after tax profits (net income after taxes) may remain in the company or may be distributed to the owners of the firm or both.

In 200Y, the company net profit margin is 0.06 or 6%. This means, for every one dollar (\$1.00) spent on purchasing assets, the company generated 6 cents in after tax profits. The after tax profits may remain in the company or may be distributed to the owners of the firm or both.

Return on Total Assets Trend:
The return on total assets has increased by 1 cent from 200X. This means the company's management team is using the assets more efficiently to generate after tax profits. Moreover, a higher return on total assets indicates the company is becoming stronger.

Return on Equity

The return on equity ratio measures how well a company is using its owner's investments to generate after tax profits (net income after taxes). Investors like to see a high return on equity since it indicates the company is uses the owner's investments efficiently to generate after tax profits. The Widget Manufacturing Company's return on equity ratios for 200X and 200Y are calculated below.

 200X 200Y Net income after taxes \$ 3,473 \$ 4,347 Total Equity \$23,473 \$32,820 =    0.148 =   0.132

As you can see, the company's 200X return on equity is 0.148 or 14.8%. This means, for every one dollar (\$1.00) invested into the business by the owners, it generated 14.8 cents in after tax profits for 200X. The after tax profits (net income after taxes) may remain in the company or may be distributed to the owners of the firm or a combination of both.

In 200Y, the company net profit margin is 0.132 or 13.2%. This means, for every one dollar (\$1.00) invested by the owners, the company generated 13.2 cents in after tax profits.

Return on Equity Trend:
The return on equity has decreased by 1.6 percent from 200X. This means the company's owners earned 1.6% less from their investment in 200Y. Moreover, a lower return on investment in 200Y, in most cases, will "disturb" the owners.

Trend Analysis Summary:

The ratio trend analysis compares a company's previous years performance to its current year performance and determines whether or not a company is improving or deteriorating. As indicated above, the Widget Manufacturing Company has improved its overall performance and is becoming a stronger company (with the exception of collecting receivables and the return on equity). Moreover compared to 200X, the company in 200Y;

- has more current assets to cover its short-term obligations;
- can rely less on its inventory to pay its short term debts;
- has fewer debts; both short-term and long-term;
- is paying less in interest charges;
- is increasing its equity base;
- making more from each product sold (lower production costs & effective price setting);
- making more after production costs, operating expenses & taxes are considered;
- is using its assets more efficiently to generate profits.

Therefore, the trend analysis can show how a company is improving internally over the years. What it does not tell a company is how well it's performing compared to other businesses within the same industry. To do this, a company would compare its ratios to ratios of similar companies within the industry. This leads us to PART 3 of our ratio analysis section entitled "Comparing Ratios to the Industry.

Categories: Financial