Updated: Wed, 06/26/2013 - 00:02

Financial ratio analysis: An essential tool for managers and investors

Ken Zapp
Ken Zapp
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Recently, while attending a monthly SCORE meeting at the Small Business Assistance Corporation conference room, I found the Risk Management Association (RMA) Annual Benchmark book.

Reading it reminded me how financial ratio analysis can be a powerful tool for business managers and potential investors alike.

RMA, founded in 1914, is a member-driven nonprofit organization dedicated to assisting the financial services industry. It has 2,500 institutional members and more than 16,000 individual members.

Originally called Robert Morris Associates, it was named after a signer of the Declaration of Independence who helped finance the revolutionary war effort and later contributed to the development of our early banking industry.

RMA’s annual benchmark book provides financial ratio data on more than 500 American industries and market segments. The data for each market are presented by firm size, defined by sales level and also by total assets.

This helps an analyst compare a firm in question to others of similar size. Billion-dollar firms have characteristics that a 100,000-dollar-operation cannot emulate.

RMA also provides three values for each ratio (within each firm size). This enables the analyst to place a firm’s results in that industry’s first, second, third or bottom quarter.

Comparing a firm’s financial ratios to those of companies in the same market can enable a manager (or creditor or potential investor) to asses the firm’s strengths and weaknesses. The latter problems may become the focus of management’s strategy for improved performance.

Financial ratios are often presented in five categories:

• Liquidity ratios measure the ability of the firm to meet its short-term obligations;

• Asset management ratios measure how efficiently the firm uses its assets;

• Debt management ratios measure the firm’s ability to meet its credit obligations and avoid bankruptcy;

• Profitability ratios show the combined effects of the first three categories on the firm’s bottom line; and

• Market value ratios reveal how the equity markets value the firm’s performance.

Though conceptually simple, financial ratio analysis has several weaknesses and implementation problems.

First, the result of this analysis rarely provides a clear positive or negative review of the firm. Most often, the analysis uncovers both strengths and weaknesses.

Secondly, firms with operations in more than one market cannot be thoroughly analyzed. Our corporate laws only require that firms release their total corporate or consolidated results.

We cannot analyze Gulfstream, for example, because its corporate owner General Dynamics only provides its overall income statement, balance sheet and statement of cash flows.

Thirdly, as seasonal factors often influence quarterly statements, we must be sure that the industry ratios and those from the firm are taken in the same quarter.

Finally, we must ensure that accounting procedures are consistent for the firm and industry and that window dressing attempts by some corporate leaders are eliminated.

We also must assume that the financial statements we analyze are accurate. Unaudited statements are always subject to question.

Remember that we always compare the firm being analyzed to similar firms. This means the same industry and similar size. We cannot compare a convenience store to Wal-Mart.

The RMA annual Benchmark book provides this information. It can be purchased by non RMA members for $380. Another source is Dunn & Bradstreet, a fee based organization. D&B, however, does not divide its industry data by firm size. Small business owners or future owners may access these data for their company through SCORE and the Small Business Assistance Corporation.

Kenneth Zapp is a professor emeritus at Metropolitan State University, an adjunct professor at Savannah State University, and a mentor for Savannah SCORE. Contact him at Kenneth.Zapp@metrostate.edu.

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