Ratio Analysis Prepared for

A common approach when evaluating a company’s financial situation from a

IRM by:
risk management perspective involves ratio analysis. We use supplier Robert J. Trent,
financial ratios to manage risk by providing insights that line-item data from Ph.D. as
financial statements cannot provide.
required
reading for
Supply Chain
Risk
Management
Certificate

0|Page
A common approach when evaluating a company’s financial situation involves ratio analysis.
Ratios, also called financial performance metrics, simply represent one number divided by
another to arrive at a value that is then compared to an industry benchmark, an internal target,
historical performance, or to other companies, usually in the same industry. Literally hundreds
of financial ratios exist. Toss some financial data into a numerator, toss some financial data
into a dominator, and poof—a ratio appears. The first test of a ratio should be that it tells us
something of importance rather than being the result of numbers thrown into a formula.

The reasons for evaluating financial ratios are straightforward. We use supplier financial ratios
to manage risk by providing insights that line-item data from financial statements cannot
provide. Ratios take financial data and turn it into value-added information that is then
interpreted. Furthermore, ratio analysis, when performed on a regular basis, can highlight
trends. Ratios can also be used to determine the relative financial strength of a supplier or
customer compared with other suppliers in an industry. Perhaps most importantly, various
tools use financial ratios to predict the potential of supplier bankruptcy. The most common
bankruptcy predictor is the Altman Z-Score.

Ratios are used at different times. Within the context of supply chain risk management,
financial ratios should be calculated when evaluating potential suppliers, especially when a
purchase requirement involves a significant amount of dollars or when buying items that are
critical to your business or product. Very importantly, ratios analysis should occur when
planning to select a supplier where switching options are difficult once a company starts using
that supplier. In other words, supplier switching costs are high, such as when entering into
longer-term contractual agreements. Finally, ratio analysis is warranted when conducting
regular risk scans of your supply base.

There are other reasons for rejecting a supplier or customer early on in the evaluation process
besides concerns about financial health. This includes, but is certainly not limited to a history of
poor performance; lack of available capacity; pending litigation involving the supplier; a supplier
that is a direct competitor; the supplier has environmental or other workplace infractions; the
supplier demonstrates relative indifference about doing business with the buyer; the supplier
has questionable ethics; and unfamiliarity with the buyer’s industry.

Financial Ratio Categories

Even though hundreds of ratios exist, most fall into one of six categories. It is important to note
that not everyone agrees on these categories. Some sources present a different mix of
categories, sometimes omitting the market and growth categories presented here and adding
ratio categories with names such as solvency, financial efficiency, cash flow, and investment
valuation ratios. Interestingly, a search of financial resources reveals that while some overlap
exists regarding financial ratio categories, complete overlap is rare. Regardless of the
categories used, each ratio category should answer a specific question or satisfy a specific
objective unique to that category.
1|Page
Here we present six ratio categories. The following describes each category:

 Liquidity ratios. Liquidity ratios help identify if a firm (i.e., the supplier) is capable of
meeting its short term financial obligations. Generally speaking, the higher the value of
the ratio, the larger the margin of safety for covering short-term debts. These ratios do
not consider long-term debt coverage.
 Leverage ratios. This category includes any ratio used to evaluate a company’s methods
of financing or to measure its ability to meet financial obligations. There are several
different ratios, but the main factors considered in these ratios include debt, equity,
assets, and interest expenses.1
 Activity ratios. Activity ratios help us understand how effectively a firm is managing its
assets. These ratios are of particular interest when considering a supplier’s supply chain
capabilities.
 Profitability ratios. This is a popular and widely used group of ratios that are almost
always included in any categorization scheme of financial ratios. Ratios in this group
indicate how well a firm is performing in terms of its ability to generate a profit.
 Market ratios. This is a set of ratios that indicate how well a supplier is performing
compared with market indicators such as price/earnings and shareholder return. The
measures in this category evaluate the current market price of a share of common stock
versus an indicator of the company's ability to generate profits or assets held by the
company.2
 Growth ratios. Growth ratios provide insight into the rate of growth over time that is
occurring at a firm for various categories such as sales or net income. These ratios are
often compared from one period to another period and require data from multiple
periods for their calculation, which is not true of the other ratio categories. Taken at a
specific point in time growth ratios will not provide much insight.

The following table provides a summary of common ratios within selected categories.

Examples of Ratios by Category

Ratio Preferred
Direction
Liquidity Current ratio: current Higher
assets/current liabilities
Cash ratio: cash/current Higher
liabilities
Quick ratio: (current assets – Higher
inventories)/current liabilities
Activity Asset turnover: sales/total Higher
assets
Current asset turnover: Higher
sales/current assets
Inventory turnover: Higher
sales/inventory
2|Page
 Inventory days outstanding: Lower
365/inventory turnover
Leverage Debt to equity: total Lower
liabilities/equity
Current debt to equity: current Lower
liabilities/equity
Interest coverage: earnings Higher
before interest and taxes/interest

Profitability Net profit margin: net Higher

income/sales
Gross margin: (sales – cost of Higher
goods sold)/sales
Operating margin: operating Higher
income/sales
Return on assets: net Higher
income/total assets
Return on equity: net Higher
income/equity

Obtaining Financial Data

A key to successful financial ratio analysis is obtaining reliable and timely data, something that
is easier said than done. One challenge is that almost all companies use suppliers that are not
publicly owned, meaning the shareholders are private owners. Private companies are under no
obligation to make financial documents available, which is not the case for publicly-traded
companies.

A second challenge is that gaining the right data about public companies can be problematic.
Large companies in particular will almost always have multiple operating units that are
aggregated in the financial statements. Breaking out specific results can be next to impossible.

A third challenge involves the use of international suppliers. The quality of financial data might
be questionable in certain parts of the world. This is particularly true when we think about
China. The “two sets of books” method, which is unthinkable (and illegal) in developed
countries is not so far-fetched in other countries. The author once held a supply chain finance
workshop in China. As the instructor reviewed ratio analysis and bankruptcy predictors, several
participants refused to participate in the exercises. When asked why they responded that
suppliers in China never let buyers see the real numbers. So, why bother with the exercises?
While this example is anecdotal, it was a revealing insight into the mindset and culture.

In practice, companies should establish an IT repository that houses supplier information

collected from multiple sources. This repository should allow access at any point during the

3|Page
supplier evaluation and supplier management process. What are some types of supplier
financial information that could be available? A partial listing includes:

 Company-published financial statements

 10-K and 10-Q reports as required by the Securities and Exchange Commission
 Dun & Bradstreet reports
 Credit reports and bank references
 3rd party supplier ratings provided by an independent firm such as Moody’s
 Trade and business journal information
 Press reports and other news releases gleaned from external sources
 Supplier provided data

This last item is particularly important. One advantage of working with suppliers over an
extended period is the opportunity to build trust through cooperative relationships. And, one
of the primary characteristics of a cooperative relationship is the sharing of data and
information. As relationships and trust evolve a supplier should be more willing to share
information with the buyer, including insights into financial and operating issues that may have
been hidden for fear of what the customer might do with that information.

Financial ratio interpretation is an art and a science. We can interpret some ratios simply from
their value. Current and quick ratios, for example, should be over 1.0. Other ratios should be
compared to benchmark values within an industry. This is something that in actual practice
should be part of the analysis. Various sources provide third-party financial benchmarks,
including Hoovers (www.hoovers.com), Bizminer (www.bizminer.com), bizstats
(www.bizstats.com), Factiva (www.factiva.com), and Mergent Online
(www.mergentonline.com).

Keep in mind that our motivation for conducting ratio analyses is not the same as it is for
financial investors. A financial investor conducts a ratio analysis to determine if a company
represents a worthy investment. The investor would like to see, for example, high profit
margins. Assuming we are not investing in the supplier, the supply manager conducts this
analysis to gain insight into the financial risks associated with entering into a purchase contract.
The supply manager likely views high margins as an indication the supplier is making too much
money at the buyer’s expense!

Final Thoughts on Financial Ratio Analysis

Some words of caution are in order when calculating ratios. Data access and the reliability of
that data is often a concern, particularly for private and foreign companies. Furthermore, ratios
analysis is simply a tool that should be part of a broader supplier evaluation and selection
process. Like measurement, ratio analysis is not a substitute for good management or sound
decision making.

4|Page
Care must also be taken when comparing companies from different industries. While the
numerical values of some ratios are interpreted similarly across industries the value of other
ratios may not be as comparable. Some industries have different perspectives about the
assumption of debt versus equity (i.e., stock), for example. When this is the case an attempt
should be made to identify industry benchmarks for comparisons.

Finally, financial statements, which are the basis for most ratios, represent only a point in time
for a balance sheet or a relatively short period of time for income and cash flow statements.
And, they are backward looking with some degree of time lag before they are issued.
Conversely, forward looking financial statements are called pro forma statements. Pro forma is
a Latin term meaning "for the sake of form.” It describes a method of calculating financial
results in order to emphasize either current or projected figures. Pro forma financial
statements are designed to reflect proposed changes, such as the expected effect of a merger
or acquisition.3

Multiple time periods should be considered during a ratio analysis to identify possible trends. A
supplier may appear less than ideal in terms of its financial statements currently but may have
improved dramatically over the last several years. One advantage of financial statements is
that many periods of data may be available for trend analysis and period-by-period
comparisons.

1
www.investopedia.com/terms/l/leverageratio.asp.
2
From www.money-zine.com/investing/investing/market-ratios/.
3
www.investopedia.com/terms/p/proforma.asp.

5|Page