Balance Sheet and Earnings Ratios

The balance sheet reports the values of assets, liabilities, and net worth as of the closing date of a reporting period (the end of the fiscal year, for example). Some important key ratios involving balance sheet accounts were explained in previous chapters, including the current ratio, quick assets ratio, debt/equity ratio, and dividend payout ratio.

Inventory Turnover

Calculate inventory turnover by dividing the cost of sales by inventory at cost. This ratio shows how well management has controlled inventory levels during the year. Ideally, higher turnover is desirable because it shows that inventory levels are not excessive. However, an extremely high turnover also might indicate that inadequate levels of inventory are maintained resulting in back orders and increased cost of sales. A trend developed to study turnover levels will show seasonal variation and enable you to track changes occurring in periods of growth or slowdown.

The calculation for inventory turnover is shown in Figure 6.1.

Some analysts prefer to use sales in place of cost of sales in the turnover calculation. This is less accurate because inventory levels are reported at cost, whereas sales are marked up. So a shift in the product lines will affect sales-based turnover and distort the ratio. For example, if one line of business is marked up 50 percent and another 100 percent, a substantial shift from one line to another in the mix of overall sales will change the turnover calculation, while inventory levels might be stable in actual practice.

FIGURE 6.1 Inventory Turnover (rounded to one decimal)

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eKEY POINT

Calculation of inventory turnover should use cost of sales, not sales. Because sales are marked up, they cannot be reliably compared to inventory at cost.

Working Capital Turnover

The current ratio, which was discussed in an earlier chapter, provides you with a general idea of the relative strength of working capital. It shows how well management keeps a balance between assets and liabilities, so that cash is available now (and will be in the immediate future) to fund operations—essential to keeping a business healthy.

One problem with the current ratio is that it does not always present a clear picture. For example, overly high cash balances, too-slow collection of receivables, and excessively high inventory levels might all be financed with long-term debt, a serious problem that does not show up in the current ratio. In such a case, the severity of the problem might become evident only when the company's stability is already compromised. To avoid this problem, compare working capital to sales.

eKEY POINT

Although current ratio is a popular and widely used ratio, it may be unreliable for spotting emerging problems in control of current asset accounts.

The calculation of working capital turnover shows how current assets and current liabilities are related to the generation of sales. This ratio assumes that working capital (the difference between current assets and current liabilities) is related directly to the production of sales volume. Because working capital is essential to the continuation of operations, there is a true relationship. In fact, calculating working capital turnover exposes artificial current ratio results. If a 2-to-1 current ratio does not adequately show excessively high account balance levels in the current asset categories, such a problem will be seen in declining turnover rates in working capital. A problem invisible in current ratio analysis may be exposed through working capital turnover trends.

FIGURE 6.2 Working Capital Turnover (rounded to one decimal)

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The calculation of working capital turnover is shown in Figure 6.2.

The number of times that working capital is used and replaced is an average, not an actual calculation of liquidated accounts. In practice, current assets and liabilities are not totally used and replaced; their relative size does change over time, however.

With this ratio, you face the same problem as that of inventory in the study of inventory turnover: Are ending balances of assets and liabilities adequate for use in this ratio? Considering that sales reflect activity over a period of time—for example, one year—and asset and liability balances reflect only the ending balances, the ratio might not accurately reflect turnover if those balances have changed.

It is probably more accurate to use averages in current accounts for the applicable period, rather than ending balances only. For example, if significant shifts have occurred from the beginning of the year to the end of the year, then the turnover analysis should reflect the significance of that change.

Finding the average for current assets and liabilities is a simple matter. If you have a published statement of cash flow, the change in current accounts will be shown on the statement itself. If you only have a balance sheet available, compare current to prior year balances. Add the two values for current assets together and divide by two; repeat the averaging process for current liabilities.