Are we earning enough income? Can we pay our bills? Will we continue to exist over the long term?

Questions like these and others arise when assessing the financial health of companies. Assessing the financial health of companies can be done in many ways, and one way is ratio analysis. A single number is a measure that quantifies an action and presents a fact. A ratio relates two or more different facts and can measure performance and relationships. Simple, but incredibly powerful if it is handled effectively! (If not, it is just another set of noisy numbers.)

Here are five steps to an effective approach to ratio analysis.

1. Study the right relationship.
2. Create comparable ratios, trended over time.
3. Search for meaning beyond the numbers.
4. Link back to strategy.
5. Use ratios with additional ratios.

Step 1: Study the right relationship.

The synonym for ratios is relationships, and this is the starting point in the process. What is the relationship you want to examine? It may be within the income statement or balance sheet or across them.

Example: Income statement ratios often relate to costs as a percentage of sales or revenue.

• The ability to establish a value proposition from the delivery of products (i.e., what is our margin or earnings/revenue).
• The effect of expensed research and development (R&D) on product revenue (i.e., R&D expense/revenue).

Example: Balance sheet ratios often relate to liquidity and working capital to determine whether a company will be able to pay its bills!

• The amount of time inventory is sold, and receivables are collected (the cash conversion cycle).
• The availability of cash necessary to pay bills in a timely manner (various liquidity ratios).
• Whether there is too much debt (debit/equity).

Example: Across statements often relate to the effectiveness of assets.

• Whether the company is making money on its big investments (i.e., return on assets revenue/assets).
• Whether investors can expect to make money on their capital (i.e., return on equity earnings/equity).

Step 2: Create comparable ratios, trended over time.

Just because you can create a mathematical relationship does not mean that you should! The old website “Spurious Correlations” may show that the consumption of cottage cheese is correlated with the number of PhDs in civil engineering, but that is not worth tracking for your business.

I like to study inventory to learn about how fast a product moves and how the company converts it to cash. I start with receivables and inventory turnover ratios to create the average collection period and the average age of inventory statistics. The reason is both ratios contain the elements of journal entries to record sales and cost of goods sold. From these elements, statistics can be created that emphasize a metric everyone understands: time. Remember, a single data point may be random, and two data points may be a coincidence, but three points make a trend!

Example: Let’s apply this step to Apple’s financial statements for fiscal years ending 2018 through 2022.

The takeaways from this table are:

• Apple’s average collection period has been volatile, with time as low as 21 days (three weeks), and as high as 33 days (five weeks). The volatility raises questions about changes in Apple’s payment terms as well as the financial health of its customers.
• Apple’s average age of inventory has been more consistent, which shows the company’s consistency in selling its products. It takes Apple approximately nine days to sell its products and approximately 40 days to collect that cash from customers.

From here, you can watch these trends over time for changes, which may indicate a change in market preference or attractiveness of the product; you can also compare to other peers to see if these numbers are competitive!

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Step 3: Search for meaning beyond the numbers.

Apple has been ranked as one of the most innovative companies in the world, and for many years, the most innovative. Apple’s innovation begins with its research and development (R&D), and its effectiveness can be measured through a relationship with the company’s sales. How can a company be described as innovative when the innovations cannot be sold?

Example: Here are Apple’s R&D to sales ratios for the last five years of their two most recent CEOs:

Do the higher ratios under Tim Cook tell us that Apple has a greater commitment to R&D under his tenure? Or do the higher ratios imply a lower payoff in sales under his tenure, perhaps due to premium pricing in the market? It would be useful to compare against the absolute amount of R&D investment, and to compare it to specific industries.

The ratios are not the end but the beginning of a process to understand how effective Apple’s R&D is in the conversion of ideas to products.

Step 4: Link back to strategy.

Numbers need to fit a narrative to have context and meaning and communicate a message. In Apple’s case, the message is whether its strategy to be an innovative, value-added consumer electronics company is seen by its stakeholders.

Example: Here is Apple’s net profit margin ratio from 2006 to 2010, the last five years of Steve Jobs’ tenure as CEO, followed by the same ratio under Tim Cook from 2018 through 2022.

Notice how the margin rose under Jobs and continued under Cook. The momentum created under Jobs' tenure as innovative and intuitive became the strong brand inherited by Cook, which led to premium pricing and strong cash flows. Apple has achieved the rare feat of high volume and high margins (indeed, among the highest in the world).

Step 5: Use ratios with additional ratios.

A single ratio may not present the entire picture of what is happening, and so additional ratios need to be examined.

Example: A good current ratio, defined as current assets divided by current liabilities, is generally 1.5 to 3.0, and this chart for fiscal years 2018 through 2022 shows that it seems to be a bit low.

Current ratios include inventory which has the potential to hide liquidity problems if a company has slow-moving inventory. We know this is not true since we saw above that the average inventory age is nine days and therefore highly liquid, but let’s pretend we did not know that and go beyond the surface with the quick ratio, defined as (current assets-inventory) divided by current liabilities:

This also looks a little low, so let’s keep going and get increased clarity of Apple’s current assets by looking at the vendor non-trade receivables as a percentage of assets, a highly quality asset that is increasing. When combined with an increasing inventory as percent of assets, we can determine that Apple believes it can quickly liquidate its current assets and therefore can hold less current assets relative to current liabilities.

About the Writer

Karl Kern is a Visiting Assistant Professor of Accountancy at Providence College. Connect with him here on LinkedIn.