PROHIBITED RATIOS

There are some ratios that either do not provide a lot of information or are almost always misinterpreted by students.  Consequently some ratios are banned from your analysis.

Cash Ratio-use the current ratio or acid-test ratio if you want to analyze liquidity

Working Capital---use the current ratio or acid-test ratio if you want to analyze liquidity

Earnings Per Share

Earnings Quality if it is a negative value.

Debt-to-Equity-use the debt ratio instead (total liabilities divided by total assets)

Ratios where the values are negative during the entire time-series you are analyzing. 

Any ratio where the denominator is negative

I also strongly recommend that you do not use market ratios such as dividend yield and the P/E ratio.  These tend to be much more complicated and in 6 semesters of teaching this class I have only seen a few excellent discussion posts that have used a market based ratio for their primary ratio.  Nevertheless if you really want to examine these ratios and are sufficiently confident in your understanding of them then I do not want to restrict you.

Step 4-Explain your definition for your primary ratio.  Provide one sample calculation for one of the quarters you are examining.  For example you might say

-I chose the current ratio.  It is defined as current assets divided by current liabilities.  For Quarter 2 in 2010 the ABC Company has a current ratio of 2.0.  Current assets are 40,250,800.  Current liabilities are 20,125,400.  So the current ratio is 40,250,800/20,125,400 = 2.0.   No need to provide this much detail for every quarter you analyze.  Once is enough for your audience to see your definition and how you calculate it.

Step 5-Discuss why you chose your primary ratio.  What can this ratio tell about the company?  Are their particular values that are significant for this ratio? For example, a ratio of 1.0 for the current ratio is generally considered significant because ratios below one usually point to a lack of sufficient liquidity.  Convince me that your primary ratio is providing insight about the company. 

Step 6-Provide a time-series analysis of your primary ratio---at least 4 years (using the same quarter each year).  You should be able to do this by examining two sets of financial statements.  If you are examining quarter 2 for the period from 2000 through 2003 you could look at the financial statements for 2001 and 2003 and that would provide you the information to make calculations for quarter 2 for each year from 2000 to 2003.  Explain what is happening with your primary ratio over the time period you are examining.  Is your ratio increasing-decreasing-trending-describe what is happening to your ratio over this time period.  Everyone should be able to complete steps 1-5.  You are just following my instructions.  This step-step6 and the remaining steps will give each student the opportunity to demonstrate their analyzing abilities and creativity in discussing something interesting and significant about the company and its situation. 

Step 7-Examine the numerator and denominator of your primary ratio.  Step 7 and especially step 8 is where each student has the opportunity to demonstrate their analyzing abilities and creativity in discussing something interesting and significant about the company and its situation.  Describe the numerator and denominator.  Describe whether they are increasing or decreasing, trending, or scattered or just what is happening with them over time.  Just like you did with the primary ratio by itself in step 6.  How much of the variation in your primary ratio is explained by the numerator or denominator?  Is one or the other the dominant reason for the value and/or the changes in the value of the primary ratio.  This is where your choice of a primary ratio becomes critical.  If you choose a primary ratio that has not varied over time and neither the denominator nor the numerator are varying then you will not have a very interesting analysis.  

Step 8-Examine your primary ratio more thoroughly.  One way would be to examine the components of the numerator and/or denominator of your primary ratio.  Suppose you have chosen a ratio where net income is in the numerator of the ratio (such as ROE or ROA or profit margin).  Net income is made up of a number of components-revenues, cost of goods sold, selling expense, depreciation expense, pension expense-there are a lot of possible expenses-gains and losses are also included.  You could provide greater insight into your primary ratio by showing how the different components that make up that ratio are performing and how they are contributing to the value and the changes in value of your primary ratio.  Suppose the primary ratio you are examining has been increasing significantly and that is why you chose it.  If you look at the components and find that some of the components are increasing and others are more stable or even decreasing then you are providing insight into what is really happening with that ratio.  Another way would be to examine a different ratio that sheds light on the situation.  I STRONGLY RECOMMEND THAT YOU DO NOT USE A SECOND RATIO from the text for this-this is generally not insightful-perhaps in only 5% of previous student posts have I been impressed when a student has tried to explain the primary ratio using a second ratio from the text.  Students generally try to then describe the second ratio they choose instead of what I want---which is to use the second ratio to help explain what is happening to the primary ratio.   Your goal is to provide as much insight into your primary ratio as possible and also provide insight into how your primary ratio provides insight about the company.