Activity Ratios

Activity ratios, also known as efficiency or turnover ratios, measure how effectively the firm is using its assets. As we will see, some aspects of activity analysis are closely related to liquidity analysis. In this section, we will focus our attention primarily on how effectively the firm is managing two specific asset groups - receivables and inventories - and its tota, assets in general.

Profitability Ratios

Profitabi I it)' ratios are of two types - those showing profitability in relation to sales and those showing profitability in relation to investment. Together, these ratios indicate the firm overall effectiveness of operation.

This ratio tells us the profit of the firm relative to sales, after we deduct the cost of producing the goods. It is a measure of the efficiency of the firm's operations, as well as an indication of how products are priced. Aldine's gross profit margin is significantly above the median of 23.8 percent for the industry, indicating that it is relatively more effective at producing and selling products above cost.

Trend Analysis

Until now, our concern has been with introducing the various financial ratios, explaining their uses in analysis, and comparing the ratios computed for our sample company with industry averages. As we pointed out earlier, it is important to compare the financial ratio for a given company over time. In this way, the analyst is able to detect any improvemen: or deterioration in a firm's financial condition and performance.

Financial Statement Items as Percentages of Totals

In addition to financial ratio analysis over time, it is often useful to express balance sheet and income statement items as percentages. The percentages can be related to totals, such as total assets or total net sales, or to some base year. Called common-size analysis and index analysis respectively, the evaluation of levels and trends in financial statement percentages over time affords the analyst insight into the underlying improvement or deterioration in financial condition and performance. Though a good portion of this insight is revealed in the analysis of financial ratios, a broader understanding of the trends is possible when the analysis is extended to include the foregoing considerations. Also, these two new types of analysis are extremely helpful in comparing firms whose data differ significantly in size, because every item on the financial statements gets placed on a relative, or standardized, basis.

Financial Statement Items as indexes Relative to a Base Year

The common-size balance sheets and income statements can be supplemented by the expression of items relative to a base year. For Harvey Electronics, the base year is 20X0, and aL financial statement items are 100.0 (percent) for that year. Items for subsequent years ar expressed as an index relative to that year. For example, comparing Harvey Electronic accounts receivable in 20X1 ($85,147,000) with its receivables in the base year, 20X ($70,360,000), the index would be 121.0 (i.e., [$85,147,000/$70,360,000] x 100). We should expect that changes in a number of the firm's current assets and liabilities accounts (e.g., cash, accounts receivable, inventory, and accounts payable - which all support sales activity) would move roughly together with sales for a normal, well-run company.

Key Learning Points

Financial analysis, though varying according to the particular interests of the analyst, always involves the use of various financial statements - primarily the balance sheet and income statement.