BAT4M-U5-L05 · BAT4M
Ratio analysis and recommendations
Learning goals
- Calculate liquidity, activity, solvency, and profitability ratios.
- Use averages and compatible numerators/denominators correctly.
- Compare ratios across time or peers while recognizing limitations.
- Turn calculations into a decision memo with evidence and next steps.
Prerequisite check
A ratio is only as reliable as its statements and definitions. State the formula, units, period, and whether averages were used before interpreting the number.
Vocabulary
- Liquidity: ability to meet near-term obligations.
- Solvency: ability to sustain long-term obligations.
- Activity ratio: measure of how efficiently assets are used or converted.
- Profitability: earning performance relative to sales, assets, or equity.
- Benchmark: relevant prior period, target, covenant, or comparable company.
- Earnings per share (EPS): profit available to common shareholders per weighted-average common share.
Core idea
Ratios compress relationships; they do not replace the relationships. Use a dashboard of linked measures and explain the business driver. Strong liquidity with obsolete inventory can be misleading; high ROA created by underinvestment may not be sustainable.
Why this treatment makes sense
Dividing balances by a meaningful base makes scale-comparison possible. Average assets, inventory, and receivables better pair a year-long flow with resources held throughout the year. Cross-checking profit ratios with cash and activity ratios tests quality.
A repeatable method
- Define user and decision: lender, manager, or investor.
- Verify consistent statements, policies, periods, units, and one-time items.
- Calculate with labelled formulas and averages where appropriate.
- Compare with history, target, covenant, and a meaningful peer.
- Connect at least two ratios and one cash/non-financial measure.
- Write finding → evidence → possible drivers → risk → next action.
Worked example
Northern Learning Corp. reports current assets $250,000 (inventory $90,000 and prepaids $10,000), current liabilities $125,000, credit sales $800,000, COGS $480,000, average receivables $80,000, average inventory $100,000, net income $72,000, EBIT $100,000, interest $12,000, average assets $650,000, ending assets $700,000, liabilities $420,000, no preferred dividends, and 60,000 weighted-average common shares.
Table: Northern Learning ratio dashboard
| Ratio | Calculation | Result |
|---|---|---|
| Current ratio | $250,000 ÷ $125,000 | 2.00 |
| Quick ratio | ($250,000 − $90,000 − $10,000) ÷ $125,000 | 1.20 |
| Receivable turnover | $800,000 ÷ $80,000 | 10.0 times |
| Days to collect | 365 ÷ 10.0 | 36.5 days |
| Inventory turnover | $480,000 ÷ $100,000 | 4.8 times |
| Days in inventory | 365 ÷ 4.8 | 76.0 days |
| Debt to assets | $420,000 ÷ $700,000 | 60.0% |
| Times interest earned | $100,000 ÷ $12,000 | 8.33 times |
| Return on assets | $72,000 ÷ $650,000 | 11.1% |
| EPS | $72,000 ÷ 60,000 | $1.20 |
Interpretation: near-term coverage appears positive, but inventory makes up much of working capital and takes about 76 days to sell. Debt funds 60% of ending assets; interest coverage is currently strong, but a downside forecast is still needed.
Journal, ledger, and statement connection
Ratios do not create entries. Reconcile each input to audited statement or note data and preserve spreadsheet formulas. If analysis reveals an omitted allowance or inventory write-down, only supported accounting evidence—not the desired ratio—justifies an adjustment.
Common mistakes
- Using ending assets with annual profit when average assets are available.
- Using sales instead of COGS for inventory turnover or total sales instead of credit sales when specified.
- Treating a ratio above 1 as automatically good.
- Comparing EPS across companies without share-count, capital-structure, or policy context.
- Choosing only ratios that support a preferred conclusion.
Guided practice
Current assets $180,000 include $70,000 inventory and $5,000 prepaids; current liabilities $100,000. Current ratio = 1.80; quick ratio = 1.05. The gap shows reliance on selling inventory to meet near-term obligations.
Independent practice
- COGS $600,000; opening inventory $110,000; ending $90,000. Find turnover and days.
- EBIT $54,000 and interest $9,000. Find times interest earned.
- Net income $48,000; opening/ending assets $380,000/$420,000. Find ROA.
- Write one follow-up question if receivable days rise from 32 to 51.
Self-check and solutions
- Average inventory $100,000; turnover 6.0; days 60.8.
- 6.0 times.
- Average assets $400,000; ROA 12.0%.
- Examples: Did payment terms, customer mix, disputes, cut-off, or overdue balances change? Review aging and subsequent cash receipts.
Retrieval practice
- Which ratio removes inventory and prepaids from current assets?
- What numerator belongs in inventory turnover?
- Why use average assets for ROA?
Answers: quick ratio; COGS; to pair a period flow with resources held across the period.
Exam-style application
A lender sees current ratio improve from 1.4 to 1.9, quick ratio remain 0.8, and inventory days rise from 70 to 118. Recommend a next step.
Model response: Liquidity may not have improved because the current-ratio gain comes from slower inventory. Inspect item aging, markdowns, subsequent sales, purchase commitments, and inventory valuation; stress-test cash available for near-term debt before approving credit or require a control/borrowing condition.
Lesson summary
Ratios are disciplined questions, not verdicts. Calculate consistently, compare meaningfully, connect measures, and turn the result into a cautious action supported by evidence.