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Key Financial Ratios



Kirjoittanut: Felix Schwarz-Pajunen - tiimistä Crevio.

Esseen tyyppi: Akateeminen essee / 3 esseepistettä.

KIRJALÄHTEET
KIRJA KIRJAILIJA
Financial Accounting for Decision Makers
Peter Atrill
Eddie McLaney
Esseen arvioitu lukuaika on 19 minuuttia.

Key Financial Ratios

by Terēze Teibe & Felix Schwarz-Pajunen

1. INTRODUCTION

Investors, banks, stakeholders, entrepreneurs and managers use different key ratios to gain valuable information about a company. This essay will explain what key ratios are and how to calculate them. It will also look at two businesses and compare them to each other by using some financial ratios.  

Learning about financial ratios is a first step to understanding a company’s financial situation within a context. To make full sense of the ratios, it is important to compare the ratios with industry standards and sometimes consider the businesses location. This gives a good indication of how well a business is doing and where it can improve. To understand a company’s stability, development and growth, analyzing its ratios and financial statements over several years is key. 

 

 

2. QUICK RECAP OF FINANCIAL STATEMENTS

 

To get financial ratios, one compares different figures from the financial statements, primarily from the balance sheet and the income statement. Every larger company produces those statements on a regular basis, at least once a year.  

The balance sheet describes the wealth of a company at a specific time (e.g. the end of the accounting year). Meaning it shows what a company owns (assets) and what it owes to others (liabilities and equity). Those two sides always need to be in balance, thus the name balance sheet. When a new balance sheet is produced, e.g. at the end of the following year, it shows the new wealth situation of the company at exactly that point in time. 

In a sense, the income statement links two balance sheets together and shows what has happened in between, it describes how profits or losses were made during a specific time period. The profit or loss from the income statement is linked to the changes of wealth of the balance sheet (Specifically the equity part) 

 

Table 1 shows a balance sheet and Table 2 an income statement of Crevio Osk.  It is a simple example since Crevio osk started trading only recently. All balance sheets and income statements follow a similar outline, but depending on industry or company form they may look a little different.  

 

TABLE 1. Crevio Osk, Balance sheet

Crevio Osk. 

Balance sheet as at 31 August 2023 

ASSETS: 

 

Non-current assets 

 

 

 

Current assets 

 

Trade receivables  

2167,00 

Cash in bank 

9716,12 

Assets total: 

11883,12 

 

 

LIABILITIES: 

 

Capital and reserves 

 

Co-operative capital  

700 

Profit (loss) 

7599,57 

Capital and reserves total:  

8299,57 

 

 

Non-current liabilities 

 

 

 

Current liabilities (Short term creditors) 

 

Trade creditors 

1501,21 

Other creditors 

2082,34 

Creditors total 

3583,55 

Liabilities total 

11883,12 

 

The balance sheet opposes assets with claims (usually equity & liabilities). In this case of a co-operative the co-operative capital and profits are included in liabilities.  

 

TABLE 2. Crevio Osk, Income statement. 

Crevio Osk. 

Income statement 1.6.2023 – 31.08.2023 

 

 

Revenue (Net turnover) 

11,190,84 

Cost of goods sold (Raw material and service) 

-2131,81 

Gross profit (Gross margin on sales)  

9059,03 

Fixed staff expenses 

-48,50 

Other operating expenses 

-1410,96 

Operating profit (Loss)  

7599,57 

Profit (Loss) before taxation 

7599,57 

 

The income statement starts with revenue. cost of goods sold are deducted to arrive at gross profit, from there operating expenses are deducted to get to operating profit. Companies might have other income or expenses that are not included in daily operations, those are added/ deducted from operating profit to finally arrive at profit for the year before taxation. Finally, one arrives at net profit which can be seen in the profit section in the balance sheet.  

 

 

3. THEORY ON FINANCIAL KEY RATIOS

 

Financial key ratios, key ratios or financial ratios. All of those are used to explain the analysis of specific ratios of company finances, but do they mean the same? Financial ratios (hence the name) stand for taking different ‘ratios’ from the company’s or enterprise’s financial statements to gain an insight into its financial health. Another way to say this, “financial ratios are a representation of financial elements in proportion to each other (D. S. Nadar & B. Wadhwa, 2019).” Further, to clear the confusion, according to Investopedia “key ratios” stand for “any financial ratio that’s considered particularly effective at measuring, illustrating, and summarizing a company’s financials in relation to its competitors or peers (Investopedia, n.d.)” While these terms have slight nuances in emphasis, either the-go-to ratio – “key ratio” (the same, “key financial ratio”) or just “financial ratio” – they all refer to the same analysis.  

Financial statement analysis gained its significance after the early 1870s when commercial banks began requesting companies to provide their financial details to show their creditworthiness in order to grant loans. Since then, financial ratios (as well as the field of financial analysis) have continued to evolve allowing us to gain an even more comprehensive understanding of various aspects of a company’s financial health. What is more, using this analysis it is possible to determine any type of organization’s foundation (current state) as well as its long-term financial position, and various insights for improvement. (Horrigan, 1968 as cited in D. S. Nadar & B. Wadhwa, 2019.)  Nevertheless, it is worth noting that with financial ratios, context is the key.   

Moreover, whilst it is imperative for any organization to regularly perform analysis on its data for efficient operation – and financial ratios are the main tools for this – it is important to remember that using all financial ratios on all of the company’s sectors would not only be resource consuming but also could lead to an inappropriate outcome. (D. S. Nadar & B. Wadhwa, 2019) That is, before performing ratio analysis, one should still be aware of the purpose for it as well as to have a clear understanding of what are the established goals of their organization (is it e.g. “to reduce operating costs”, “to increase profit” or “to understand whether it is worth investing in another project”). There are hundreds of possible ratios, but usually only a few are needed to gain an understanding about the entity (AccountingTools, 2023a). Additionally, the data gained from ratio analysis usually provides more value when it has a comparison. Either it is the data of the company’s previous year’s performance or that from a similar competitor which is comparable (‘barber shop vs barber shop’ rather than ‘bar vs shopping centre’).   

In an educational material, “Financial Accounting” authors highlight four valid indicators (benchmarks) for better comparison of financial ratio analysis. Those four are as follows (Britton & Waterston 2003, 180): 

  • Past period achievements; 
  • Budgeted achievements; 
  • Other (similar) business’s achievements; 
  • Averages of business achievements in the same area. 

 

Furthermore, different parties are interested in the financial health of a company, and all of them have other needs and objectives for accounting information. For example, investors and owners are interested in how to manage their investments to increase their value. Suppliers – whether the business will repay their goods bought on credit. Customers are interested in whether they will be able to receive their purchased goods on time as well as “will the business continue its operation”. Whereas lenders would be more focused on the financial security of the company and whether it will be able to repay its debts as promised. Finally, the employees of the company too care to know whether the business generates a sufficient amount of profit to make all the necessary payments to continue its existence (and so promise long-term employment security) as well as to be able to pay out all salaries on time. (Britton & Waterston 2003, 178-181.) 

 

 

4. EXAMPLES OF KEY RATIOS

 

Most financial ratios are calculated by taking data from the balance sheet or the income statement. This part of the essay will explore few examples of ratios from profitability ratios, liquidity ratios, efficiency ratios, leverage ratios and price ratios – all of which can be found valuable for Proakatemia team companies and that can be derived from both financial statements.   

 

4.1 Profitability ratios 

Profitability ratios measure how well business is at generating profit from revenue, assets, equity and capital employed. They can be divided into two smaller groups – margin ratios and return ratios. The data is taken from the income statement and the balance sheet. (Accounting Stuff, 2022; AccountingTools, 2023a). 

 

Margin ratio group: measure how well a business converts its revenue into profit.  

The data is taken from the income statement. 

 

* “/” (division sign) 

 

  1. Profit Margin = Profit / Revenue

One can choose which profit (gross profit, operating profit or net profit) is relevant in their calculation.  

 

For example: 

Gross Profit Margin (GPM) reveals how much gross profit (revenue – direct cost of sales (it can also be found as ‘goods sold’ or ‘cost of services’) a business generates from each dollar (or euro) of revenue earned. When the result is multiplied by 100, shows what percentage of revenue a business is able to convert into profit. GPM ignores the operating expenses, interest and tax. In this case, bigger is better. (Accounting Stuff, 2021; Accounting Stuff, 2022). 

 

  1. 1) GPM = Gross Profit / Revenue

 

What can increase or decrease GPM? 

Increase can happen if there are higher sales prices, change in the sales mix in favor for higher margin products or if the cost of goods sold has decreased in comparison with the revenue generated. A decrease happens when the cost of goods has increased if compared with the revenue generated or by lower sales prices. (Accounting Stuff, 2021a.) 

 

Further, when subtracting the operating expenses from gross profit, we get operating profit. Therefore, Operating Profit Margin (OPM) formula is as follows: 

 

  1. 2) OPM = Operating Profit* / Revenue

* Operating profit = Gross Profit – Operating Expenses 

 

OPM key ratio shows what is business’s financial gain after deducting direct cost of sales and operating expenses, but it ignores interest and tax expenses.  

 

What can increase or decrease OPM? 

OPM can increase when GPM has increased or if the operating expenses have decreased in comparison with revenue, and vice versa, decrease can happen if GPM has decreased or if the operating expenses have increased but the revenue generated has decreased. (Accounting Stuff, 2021b.) 

 

The net profit is the final profit after deducting all of the business expenses. Net Profit Margin (NPM) formula is similar to the previous two examples: 

 

  1. 3) NPM = Net Profit / Revenue

 

Return ratio group: the data is taken from the balance sheet and the income statement. 

  

  1. Return Ratio = Net Profit/ Assets or Equity or Capital Employed

 

For example, (2.1) Return on Assets (ROA) = Net Profit / Total Assets 

 

ROA shows how to efficiently use assets to generate profits. When calculating ROA, net profit is taken from the income statement whereas ‘total assets’ come from the balance sheet. Important note here, it is important to remember that income statement covers longer period of time whilst a balance sheet is snapshot of the point in time. That is why it is suggested to  use the average of opening and closing balance sheet numbers. (Accounting Stuff, 2022). If the numbers are low (low return), it indicates a bloated investment in assets (AccountingTools, 2023a). 

 

Performance is mostly assessed by the return on capital employed ratio. Return on Capital Employed (ROCE) shows how much profit business has generated from the invested capital as well as answers whether to leave the money in the company. (Britton & Waterston 2003). It is also more useful for businesses that take out larger loans to fund their operations (Accounting Stuff, 2023).  

 

       2.2) ROCE = Net Profit* / Capital Employed 

* can use also operating profit (earnings before interest and tax) 

 

How can it be increased? 

ROCE increases if the net profit margins, or the volume of trade has increased in comparison to capital employed (Britton & Waterston 2003).  

 

4.2 Liquidity ratios 

Liquidity ratios measure how well a business can cover its short-term debt obligations using different assets (Accounting Stuff, 2022). Liquidity ratio analysis is particularly important for lenders and creditors as it shows whether their borrower or customer can pay its bills in a timely manner before granting them a credit. In liquidity ratios one compares liquid assets to short-term liabilities. (AccountingTools, 2023b.) The data is taken from the balance sheet. 

 

  1. Liquidity Ratio = Group of current Assets* / Current Liabilities**

* assets used to cover a business’s short-term debt,  

** short-term debt obligations (those that need to be paid within one year). 

 

Cash is the most liquid asset. If the Cash Ratio is bigger than 1, then a business is able to resolve all of its short-term obligations using only cash. This is one indicator of good financial health. (Accounting Stuff, 2022.) 

 

     3.1) Cash Ratio = Cash / Current Liabilities 

 

If, however, the cash ratio is less than 1, it does not end there. A business has other liquid assets too that can still be converted into cash in a short period of time (such as short-term investments and accounts receivable). Quick Ratio includes, apart from cash, also accounts receivable and short-term investments, but it excludes inventory. Current Ratio, on the other hand, counts all of the assets (including inventory and pre-paid expenses). Inventory and pre-paid expenses are not considered liquid assets. Therefore, quick ratio is considered better indicator of the company’s ability to repay its obligations since there can be challenges when turning inventory into cash, particularly if it is outdated. (Accounting Stuff, 2022; AccountingTools, 2023c.) 

 

Formulas: 

 

3.2) Quick Ratio = Liquid Assets* / Current Liabilities 

Liquid assets – cash, short-term investments and accounts receivable 

 

       3.3) Current Ratio = Current Assets / Current Liabilities  

 

 

4.3 Efficiency Ratios 

Efficiency ratios measure how effective business generates sales using its assets and liabilities. That is, comparison between assets and sales. Efficiency Ratios are then divided into turnover ratios and cash conversion cycle. (Accounting Stuff, 2022; AccountingTools, 2023d.) 

 

Turnover ratios: measure efficiency with which a business carries out its operations. The data is taken from both income statement and the balance sheet. 

 

For example: 

 

       4.1) Inventory Turnover = Cost of Goods Sold*/ Inventory** 

        *from income statement, ** from balance sheet 

 

      4.2) Receivables Turnover = Revenue / Accounts Receivable 

 

Inventory turnover ratio measures how many times a business has sold and replenished its inventory whereas receivables turnover measures the efficiency of cash collection from customers (Accounting Stuff, 2022). 

 

Cash conversion cycle: measures the average number of days a business needs to convert its investments into cash.   

 

  1. Cash Conversion Cycle (CCC) = Days Sales of Inventory + Days Sales Outstanding + Days Payable Outstanding. 

 

Formulas: 

 

    5.1) Days Sales of Inventory (DSI) = Inventory*/ Cost of Good Sold** x 365  

    *from income statement, ** from balance sheet 

 

    5.2) Days Sales Outstanding (DSO) = Accounts Receivable / Revenue x 365 

 

    5.3) Days Payable Outstanding (DPO) = Accounts Payable*  / Cost of Goods Sold**  x 365 

    *from income statement, ** from balance sheet 

 

Days Sales of Inventory (DSI) measures the average number of days to convert its inventory into sales. Days Sales Outstanding (DSO) – the average time it takes for a business to collect payment from sale, measured in days, and DPO – the number of days it takes for a business to settle its payables. (Accounting Stuff, 2022.) 

 

 

4.4 Leverage Ratios  

Leverage ratios measure the debt load within the business. Their focus is to gain an insight about company’s financial risks and overall stability. There are multiple leverage ratios and each of them focuses on different aspects of a company’s debt profile. These ratios can again be split into two subcategories – balance sheet ratios and income statement ratios. (Accounting Stuff, 2022; ChatGPT.) 

Balance sheet subgroup: 

  

    6.1) Debt to Assets Ratio = Total Liabilities / Total Assets 

Debt to assets ratio measures how much business’s assets have been financed using debt, considering both short-term and long-term obligations. (Accounting Stuff, 2022.) 

  

    6.2) Debt to Equity Ratio (DTE) = Total Liabilities / Total Equity 

Debt to equity ratio measures debt for each dollar (euro) of equity. (Accounting Stuff, 2022.) 

  

Income statement subgroup: 

  

    6.3) Debt Service Coverage Ratio (DSCR) = EBITDA* / Total Debt Service 

    *EBITDA – earnings before interest, tax, depreciation and amortization 

DSCR measures whether business generates enough profit to cover its debt obligations with its operating income. If the result is higher than 1, it is a positive indicator. (Accounting Stuff, 2022, ChatGPT.) 

  

 

4.5 Price Ratios 

Price ratios evaluate the share price of a business. Often used by investors to determine whether it is a worthwhile investment, and whether the current stock price aligns with the company’s financial performance and growth prospects. They again split on two subgroups – dividend ratios and earning ratios. (Accounting Stuff, 2022; ChatGPT.) 

  

Example from earning ratios subgroup: 

     Example: 

     7.1) Earnings per Share (EPS) = Net Profit / Number of Common Shares Outstanding* 

    * number of common shares can be found in the equity section in the balance sheet  

Earnings per share measure company’s profitability on a per-share basis. EPS can also be =    Net Profit Preferred Dividends / Common Shares Outstanding. (Accounting Stuff, 2022; ChatGPT.) 

  

To conclude this part, this section aimed to illustrate some examples in diverse range of key financial ratios. It is essential to acknowledge that the field of financial ratios is very broad, and covers various metrics to measure different parts of a company’s performance. What is more, many ratios can be segmented further or customized to further fit the specific objectives of an analysis. 

 

 

5.APPLICATION

 

The original intention of this practical application was to compare a local McDonalds with a local Hesburger. In Finland all companies must disclose their financial statements to authorities (also companies that are not public). Those documents are available to the public at the Finnish Patent and Registration Office against a small fee.  

While it is very interesting to analyze the financial statements of companies one is familiar with, the restaurants’ numbers and resulting ratios were not particularly useful for clear comparison and good learnings for beginners when it comes to financial ratios. Both restaurants seemed to have gone through a lot of change and did not perform close to the industry standards. 

Limited companies do not need to provide further explanation of their financial year or business in general. This results in limited understanding for the outsider.  

Listed companies, on the other hand, must share reports and are interested in sharing about significant changes to their shareholders. Their information is also much easier to find and better documented. Their continuity and traceability make them good examples for learning and comparison. Thus, two listed companies, Volkswagen AG and Toyota Motor Corporation, were chosen for the practical application. The companies were the two biggest car manufacturers in the year 2021. 

When doing financial analysis, the first step is to get the financial statements of the companies in question and arrange them in a similar way. While accounting regulations dictate that companies use a similar layout when preparing financial statements, depending on industry, company form, and accounting practices, they may look slightly different.  

To make analyzing easier one needs to match all line items from the companies in question. 

Financial analysts and investors use services that provide “common form financial statements” that make comparison easy. Examples of those services include Bloomberg and FactSet as paid services and Yahoo Finance and Macrotrends as free services. (Business Basics Essentials, 2022)   

For the comparison in this essay all the numbers presented in the following tables and figures come from the database of macrotrends.net (Macrotrends.net, 2023a) (Macrotrends.net, 2023b). The authors used the data and created their own tables and figures to convey different points.  

Table 3. compares the data of the income statement of Volkswagen and Toyota in the year 2021 with each other. Table 4. compares the data of their balance sheets with each other. Additional information about a company’s growth and stability can be gained if one looks at e.g. the last ten years of the company.  

 

TABLE 3. INCOME STATEMENT, VW vs. Toyota. 

INCOME STATEMENT, VW vs. Toyota. For year ended 31.12.2021 (Millions USD)  

 

VOLKSWAGEN 

TOYOTA 

Revenue (Net turnover) 

296 011,60 

255 817,20 

Cost of goods sold  

240 120,80 

210 605,80 

Gross profit  

55 890,83 

45 424,31 

RND expenses 

 

 

SG&A expenses (Operating expense) 

22 748,65 

24 765,47 

Other operating Income (or Expenses) 

1 989,97 

 

Total operating expenses  

33 086,60 

24 765,47 

Operating Profit 

22 804,25 

20 658,84 

Total Non-operating Profit (Loss) 

1 005,63 

6 905 296 

Profit (Loss) before taxation 

23 881,07 

27 564,14 

Income tax 

5 558,20 

6 109,77 

Profit after taxes 

18 252,87 

21 454,35 

Net Profit  

17 560,75 

21 105,45 

 

TABLE 4. BALANCE SHEET, VW vs. Toyota.

BALANCE SHEET, VW vs. Toyota. as of 31.12.2021 (Millions USD)  

 

VOLKSWAGEN 

TOYOTA 

ASSETS: 

 

 

Non-current assets 

 

 

  • Property, Plant, and equipment  

75 357,55 

107 264,80 

  • Investments 

18 374,73 

124 500,30 

  • Goodwill and Intangible Assets 

91 913,86 

10 421,16 

  • Other long-term assets  

11 583,73 

5 169,45 

Total non-current assets 

388 366,80 

371 209,1 

 

 

 

Current assets 

 

 

  • Cash on Hand 

73 653,89 

87 573,35 

  • Receivables  

95 961,24 

92 377,45 

  • Inventory 

51 731,05 

27 147,46 

  • Pre-Paid Expenses 

 

7 003,65 

  • Other current assets  

14 888,13 

 

Total current assets 

237 030,50 

214 101,90 

TOTAL ASSETS: 

625 397,30 

585 311,10 

 

 

 

LIABILITIES  

 

 

Non-current liabilities  

 

 

  • Long term dept 

 

126 407,20 

  • Other Non-current Liabilities  

202 759,70 

7 411,45 

Total non-current liabilities  

257 988,00 

155 272,40 

Current liabilities 

 

 

Total current Liabilities  

194 493,40 

201 728,40 

TOTAL LIABILITIES: 

452 482,50 

357 000,80 

 

 

 

SHARE HOLDER EQUITY 

 

 

  • Common Stock Net 

1 517,91 

3 732,27 

  • Retained Earnings (Accum. Deficit) 

138 827,30 

226 579,30

  • Comprehensive income 

 

 

  • Other Share Holders Equity 

13 335,90 

12 292,62 

TOTAL Share Holders Equity 

172 914,80 

228 310,30 

 

 

 

TOTAL EQUITY & LIABILITIES 

625 397,30 

585 311,10 

 

 

6. ANALYSIS 

 

The following analysis is indented as an example and covers some selected ratios since a comprehensive examination of all ratios described above is beyond this essay’s scope. Before one starts to calculate ratios, a simple examination of the numbers gives already much insight. Comparing the numbers to the previous years, looking for any abnormalities and trying to trace them gives first insights.  

The top line on the income statement is revenue and serves as an important starting point.  Volkswagens (hereafter VW) topline is bigger than Toyotas, which makes VW the number one car manufacturer in the world, measured by revenue.  Figure 1. shows the two companies’ revenue history between 2011 and 2021. Both companies seem quite stable with Toyota being a bit more consistent. 

 

 

FIGURE 1. Volkswagens & Toyotas Revenue 2011-2021  

 

If one zooms in on the y-axis and displays only the numbers between 200 000 million and 300 000 million, like done in Figure 2, one can see the fluctuations better.  

 

FIGURE 2. Zoom of Volkswagens & Toyotas Revenue 2011-2021  

 

Looking at the change from 2020 to 2021, naturally one would further investigate the reason for the positive change for VW and one would especially want to investigate what caused the negative development for Toyota. This information would be important for management to understand why sales dropped so significantly and what to do about it.  

 

Moving down on the income statement, Toyota, while having less revenue, has still a better bottom line, which indicates that the company operates more efficiently and is more profitable. To know how much that difference is in percentages, one can calculate some profitability ratios as seen in Table 5.  

 

TABLE 5. Profitability Ratios  

Profitability Ratios  

Volkswagen 

Toyota 

Gross Profit Margin 

18,88% 

17,76% 

Operating Profit Margin 

7,70% 

8,08% 

Net Profit Margin 

5,93% 

8,25% 

 

 In this case, higher margins are better, since it represents the percentage left from the original sale. Meaning that for every 1 dollar sold, VW had about 19 cents left to cover operating expenses, and finally 5,9 cents left as net profit.  

When comparing the two companies, the percentages seem quite similar but with the sums those companies deal with, one percentage makes a significant difference. So much so that, as mentioned above, compared to VW, Toyotas net profit is higher even thought their sales were lower. This makes Toyota the more profitable company.  

Figure 3. shows the two companies’ net income (net profit) between 2011 and 2021. Overall Toyota is the more consistent company when it comes to profit. 

 

FIGURE 3. Volkswagens & Toyotas Net income 2011-2021 

 

Even with revenue dropping significantly from the years 2020 and 2021, Toyotas net profit increased. This would be worth investigating. In general, Toyota is known for very lean operations, in fact, “the roots of Lean can be found in the Japanese company of Toyota” (Dekier, 2012). This seems to reflect in their numbers as well (Van Stekelborg, 2020). 

 

For investors and analysts interested in the auto industry, the dept to equity ratio, the inventory turnover ratio and the return on equity ratio are the most important ones (Maverick, 2023). Table 6. shows the results of those ratios.  

 

TABLE 6. Results of various ratios.  

 

Volkswagen 

Toyota 

Dept to Equity Ratio 

2,62 

1,56 

Inventory Turnover Ratio 

4,64 

7,76 

Return on Equity Ratio 

10,16 

9,24 

Current Ratio 

2,00 

1,84 

 

A Debt-to-Equity ratio of 1 indicates that a company’s total debt (total liabilities) is equal to its total equity, meaning that 50% of its capital comes from dept and 50% from owners’ equity. If the dept to equity ratio is higher, it means the company is financed by creditors (dept) rather than equity (owners). A lower ratio is better, and it should not be higher than 2. Toyota’s ratio is on a good spot considering the industry and VW’s is quite high, but in fixed assets- heavy industries like car manufacturing it is not uncommon to be higher than two. (Maverick, 2023.) 

 

The inventory turnover ratio indicates how often inventory is sold per year. In Toyotas case it’s 7,7 which means that the company has sold its entire inventory about 7,7 times per year. In this case, a higher number is better. VWs inventory turnover ratio is 4,6 which is lower. This could indicate overproduction which could mean that inventory needs to be held longer. This is related to higher costs and risks such as the risk that the inventory becomes obsolete, and capital tied up in inventory can’t be used for other things which is is known as cost of opportunity and the basic cost of keeping inventory (Artill, McLaney 2008, 216).  

 

The return on equity ratio is especially interesting for investors since it measures how much one can gain from investments. In the first quarter of 2022 the industry average was 15,86% (Maverick, 2023).  For the year 2021, VW provided a higher return for investors than Toyota did.  

Return on equity is calculated by dividing net profit by average shareholders’ equity times 100. While Toyota was more profitable, it had more shareholder equity than VW, making for less returns for each share.  

 

Overall, from this short comparison, Toyota seems to have better operations and systems in place and seems more stable over the years. VW has better revenue in 2021, which does not really mean that much. They also had a better return on equity. The abnormalities & significant changes between the last years, both in ratios and line items on the financial statements would need to be addressed more closely to see which direction the company is going and what the reasons for it where.  

 

 

 7. CONCLUSION

 

While writing this essay we realize that the examples given barely scratched the surface of financial analysis, each item on the financial statements and each ratio could be analyzed and compared deeper and background research would reveal more insights. But, as mentioned earlier in the essay, one always needs to consider why one analyses a certain thing since useless analyzing can be time consuming and futile. The field of financial analysis is vast and while entrepreneurs do not need to master every aspect of it, they do need to be financially savvy. Understanding the basic concepts mentioned and how things like inventory and operational efficiency affect the number goes a long way to building stable, thriving businesses.  

To finish with something more relatable than the enormous car industry, Will Guidara, a successful restauranteur from New York writes in his book Unreasonable Hospitality about how important it was for his success to not only learn how to manage a kitchen or a dining room but also the back end, the accounting and the inventory management. He claims that “…whatever terrifying statistic you’ve heard about how many restaurants fail in the first year has a lot more to do with the people who open restaurants without the understanding the business part of the business” (Guidara, 2022) then with it being hardly possible to succeed as a restaurant. Entrepreneurs will be more likely successful if they understand their numbers, the concepts of financial management and how finances and daily operation decisions connect.   

 

 

 

 

 

 

References 

 

Accounting Stuff. 2022. FINANCIAL RATIOS: How to Analyze Financial Statements. ACCOUNTING BASICS for Beginners. Content video. 15.08.2022. https://youtu.be/3W_LwpeG8c8?si=Hc8EXngyd68Kshkp [7.11.2023]  

                        

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