Ratio Analysis

Topics: Balance sheet, Generally Accepted Accounting Principles, Asset Pages: 20 (2593 words) Published: September 27, 2013
Financial Reporting II
Review of Ratio Analysis

Ratio analysis is a useful tool for analyzing financial statements. Calculating ratios will aid in understanding the company’s strategy and in understanding its strengths and weaknesses relative to other companies and over time. They can sometimes be useful in identifying earnings management and in understanding the effect of accounting choices on the firm’s reported profitability and growth. Finally, the ratios help in obtaining a better understanding of a firm’s current profitability, growth, and risk which can improve forecasts of future profitability and growth and estimates of the cost of capital.

In reviewing the basic financial ratios, we will examine the ratios of Best Buy for the fiscal years ended March 2, 2002 and March 3, 2001. Excerpts from Best Buy’s financial statements are included at the end of this document. Best Buy is a growing company. The following table reflects the growth in sales and income during the year ended March 2, 2002:

Year Ended
March 2, 2002
Year Ended
March 3, 2001

% Growth
Net Income
Average book value
Average assets
Average debt

Note that sales and net income rose in 2002 relative to 2001. Also note, however, that total assets, book value and debt also rose during the year. Ratio analysis allows the analyst to compare the income and sales reported on the income statement relative to the assets and book value the company had to work with reported on the balance sheet. A review of the ratios follows.

Profitability Ratios
Return on Assets
Return on assets measures a firm's performance in using assets to generate earnings (independent of the financing of the assets). This measure allows one to consider the income (before financing costs) relative to the assets that the firm had to generate the income. It, therefore, allows one to examine the income statement in relation to the resources available as reported on the balance sheet. Return on assets (ROA) is calculated as follows:

Net Income + Interest Expense*(1-tax rate)
Average Total Assets

Best Buy (assuming that Best Buy’s income tax rate is 35% for both years)

570 + 28 (.65)

= 9.63%
396 + 7 (.65)

= 10.22%
Note that while Best Buy’s earnings rose from 2001 to 2002, the earnings generated per dollar of assets fell over the period. In 2001, Best Buy earned 10.22 cents before financing costs on every dollar of average assets; however, in 2002, Best Buy earned only 9.63 cents before financing costs on every dollar of average assets. The ratio, return on assets, allows the analyst to compare the earnings generating ability of the company relative to the invested assets.

Disaggregating Return on Assets
A firm’s return on assets reflects the income (before financing costs) generated from the firm’s assets. The ROA can be disaggregated into the sales generated from the assets and the income (before financing costs) generated from the sales. Return on assets is often disaggregated into profit margin (PM) and asset turnover (ATO):


This disaggregation allows the analyst to better understand the source of the change in return on assets. For example, did Best Buy’s ROA fall in 2002 because it had more difficulty generating sales from the assets (ATO) or because it had difficulty generating income from the sales (PM), or both? An analysis of ATO and PM can yield insights into the source of the change in ROA.

Profit Margin Ratio
The profit margin ratio (PM) measures a firm's ability to control the level of expenses relative to the revenues generated. PM is calculated as follows:

Net Income + Interest Expense*(1-tax rate)

Best Buy

570 + 28 (.65)

= 3.00%
396 + 7 (.65)...
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