MBA 620 Financial Decision Making Project 2 Step 2: Evaluate Business Performance Using Ratio Analysis
MCS asks that analysts review the financial health of the client’s business by completing ratio analysis. Frank explains that Choice Hotels has an aggressive strategy to grow revenues and stock price. The company does this by accepting ratios that might be outside normal industry ranges.
Ratio analysis is an analytical tool for understanding financial results and trends over time, and for providing key indicators of organizational performance. Typically, ratios are calculated by using data from the income statement, balance sheet, and statement of cash flows. This information can be found in the 10-K Document. MCS uses a customized worksheet to report ratio calculations, results, analysis, and recommendations for clients.
Financial ratios are used for many types of businesses in various industries. For a hospitality business such as Choice Hotels, you have selected a set of financial accounting ratios that are most appropriate for the client.
Frank stops by your office to give a few pointers:
Dialogue with Frank Marinara
“Choice Hotels would like us to look at their balance sheet and provide them with guidance on what they should or should not do to better manage their assets.
“Balance sheet ratios like the fixed-asset turnover ratio are commonly used in the valuation of inventory,” he adds. Other balance sheet ratios include working capital.”
Your ratio calculations should be completed in the Ratio Analysis worksheet in the Project 2 Excel Workbook.
Complete the workbook with data from the Income Statement, Balance Sheet, and Statement of Cash Flows worksheets. As part of your analysis of Choice Hotels’ strategy, you will also need to answer a few questions in the worksheet.
When you have finished, submit the workbook to the submission folder located in the final step of this project.
When you have completed Step 2, proceed to Step 3, where you will discuss accounting ethics.
Financial Accounting Ratios
Ratio analysis is one of the essential tools for evaluating a company’s financial health. It’s not just about calculating ratios; it’s about interpreting the ratios and seeing changes, opportunities, and threats. Ratios are only as good as the mind that analyzes them.
Ratios are divided into categories depending on what they analyze.
Asset Management Ratios
Asset management ratios tell how well a firm is managing its assets.
Total Asset Turnover
The total asset turnover ratio gives us an idea of how effectively a firm uses its assets to generate sales. It is computed by dividing total revenues by total assets for the same time period. This ratio can be compared to other firms in the industry or to this firm in prior years. If the asset turnover ratio is relatively high, then the firm is efficiently using its assets to generate sales. If it is relatively low, then the firm is not using assets effectively and may want to consider selling some assets if sales do not increase.
net sales ÷ average total assets
revenues (per year) ÷ average total assets
Receivables Turnover Ratio
The receivables turnover ratio, or accounts receivable turnover ratio, measures how capable the company is in collecting money owed to them or how efficient they are in extending credit and collecting debts. It is the total revenue divided by the average receivables. Apparently, we would like to get our money and sooner is better than later!
net credit sales (or net sales) ÷ average accounts receivable
Liquidity ratios measure the ability of a business to meet its short-term financial obligations. These ratios are associated with a firm’s working capital.
The current ratio is computed by dividing current assets by current liabilities. The current ratio measures the ability of a company to repay its current liabilities.
current assets (CA) ÷ current liabilities (CL)
The quick ratio was given the nickname acid test after a method used by gold miners to confirm their nuggets were real gold. The nuggets gold miners discovered were dipped in acid. Most metals will dissolve in acid and fail the test—except the real deal: gold. Financially, the acid test measures the ability of a firm to pay its liabilities with the real deal: cash. The acid test measures if a company can pay its current liabilities without relying on the sale of its inventory. In the acid test, we subtract inventories from current assets and then divide by current liabilities. The acceptance range for the actual value depends on the industry, but a quick ratio greater than one is usually recommended. The quick ratio is a better measure when a firm’s inventory cannot quickly be converted to cash. If a firm has an inventory that is liquid, the current ratio is preferred.
quick assets (cash + marketable securities + net receivables) ÷ current liabilities
Debt Management Ratios
Debt management ratios measure how much a firm uses debt as a source of financing. These are also referred to as equity or solvency ratios. When a company uses debt financing, they use other people’s money to finance their business activities. Debt has higher risk but also the potential for a higher return. Debt has an impact on a company’s financial statements. The more debt a company uses, the greater the financial leverage. Because with debt the stockholders maintain control of the firm, the more debt a company uses, the greater the financial leverage and the greater the returns to stockholders. With the debt ratios, we try to measure the indebtedness of the firm, which gives us an idea of the riskiness of the firm as an investment. There are two types of measures of debt usage. The first is the ability of the company to pay back its debts. The second is the degree of the indebtedness of the firm. The first measure of the amount of debt a firm has is the debt ratio. Any discussion of greater leverage needs to be clear about greater risk.
The debt ratio is the ratio of debts to assets (in actuality total liabilities to total assets), or, how much is owed in liabilities for every $1 in assets. It measures the percentage of funds provided by current liabilities and by long-term debt. Creditors prefer low debt ratios because a low ratio indicates that the firm has plenty of assets to pay back its debts. In other words, the firm has a financial “airbag” in case of an accident, which will protect against a creditor’s losses in the event of bankruptcy. On the other hand, a stockholder may prefer a higher ratio because that indicates the firm is appropriately using leverage, which magnifies the stockholder’s return. Simply put, the debt ratio is a percent. It is the percent of financing in the form of liabilities and is an indicator of financial leverage.
total debt ÷ total assets
A close cousin of the debt ratio and another version of the indebtedness of a firm is the debt-to-equity ratio, also known as the debt-equity ratio. The debt-to-equity ratio presents the information in a slightly different way. It subtracts total liabilities from total assets in the denominator. This calculation is easy to comprehend because it shows us dollars of debt for every dollar of equity.
Total debt includes notes payable, bank debt, current portion of long-term debt, and long-term debt.
debt ÷ equity
Return on Equity
Two of our the most commonly used ratios are return on equity (ROE) and return on assets (ROA). Both ratios are return on an outlay. ROE is the ratio of net income to total equity. This ratio tells us the return investors are earning on their investment. The higher the ratio better.
ROE = net income ÷ equity
We love to focus on profit, the so-called bottom line. Ratio analysis helps us to put our profit number into context. These ratios used together can help give a clear picture of the profitability of a firm.
Return on Assets
Return on assets (ROA) is the ratio of net income to total assets. This measures the manager’s overall effectiveness in creating profits with the firm’s assets. The higher the ratio, the better.
ROA = net income / assets
Net Profit Margin
Net profit margin is the percentage of each sales dollar that remains after all expenses have been deducted. Expenses including interest, taxes and preferred stock dividends. This can sometimes be referred to as net profits after taxes divided by sales. In this situation, higher is also better, but what is considered to be a good profit margin varies significantly across industries.
profit margin = net income / sales or revenues
Operating Profit Margin
Operating profit margin only uses operating expenses to calculate. It does not consider items such as depreciation, interest or taxes. In this case, higher is also better.
operating income / sales or revenues
Market Value Ratios
Market value ratios, also called investment valuation ratios, relate a firm’s value as measured by stock price to other accounting measures such as earnings and cash flow. These are a way to measure the value of a company’s stock relative to another company’s stock.
The dividend yield is how much in dividends you receive based on every dollar of the market price per share.
dividend per share ÷ price of one share of stock
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