Ratios

Pure Balance Sheet and Pure Income Statement Ratios

Pure income statement and pure balance sheet ratios are unaffected by the application of the current rate method. In other words, the local currency trends and relationships are “preserved.” What we mean by “pure” is that all of the components of the ratio are from the balance sheet, or all of the components are from the income statement.

For example, the current ratio (current assets / current liabilities) is a pure balance sheet ratio because both the numerator and denominator are from the balance sheet and are translated at the current rate. If you multiply both numerator and denominator by the same exchange rate, the rate cancels, and you’re left with the same ratio.

All profit margin measures are pure income statement ratios because both the numerator (gross profit, operating profit, or net profit) and the denominator (revenue) are from the income statement and are translated at the average rate.

Selected pure balance sheet and pure income statement ratios from the Vibrant example are presented in Figure 9.6. Notice the current rate method preserves the original LC ratio in each case.

Figure 9.6: Vibrant Pure Balance Sheet and Pure Income Statement Ratios

Mixed Balance Sheet/Income Statement Ratios

A mixed ratio combines inputs from both the income statement and balance sheet. The current rate method results in small changes in mixed ratios because the numerator and the denominator are almost always translated at different exchange rates. The change will likely be small and the direction will depend on the relationship between the exchange rate used to translate the denominator and the exchange rate used to translate the numerator.

Our analysis of mixed ratios isn’t as clear cut as the analysis of pure ratios, but we can make one definitive statement: mixed ratios calculated from financial statements translated using the current rate method will be different than the same ratio calculated from the local currency statements before translation. However, we can’t make any definitive statements about whether specific ratios will be larger or smaller after translation unless we make the assumption that all mixed ratios are calculated using end of period balance sheet figures. The analysis that follows does not necessarily apply for mixed ratios calculated using beginning or average balance sheet figures.

This is a very important point so we’ll repeat it again: the conclusions drawn in the following section assume we’re using end of period balance sheet figures.

Selected mixed balance sheet and income statement ratios from the Vibrant example are presented in Figure 9.7. Recall that during 2022, the loca depreciated relative to the parent’s presentation currency, the U.S. dollar.

Figure 9.7: Vibrant Mixed Balance Sheet/Income Statement Ratios (Depreciating LC)

Notice that in each case the translated ratio is larger than the original ratio. This will always be the case when the foreign currency is depreciating because the average rate (which is used in the numerator of the ratio) is greater than the ending rate (which is used in the denominator of the ratio). When the foreign currency is appreciating, each of these ratios will decrease.

The same is true for the inventory processing period.

On the exam, remember these key points regarding the original versus the translated financial statements (using the current rate method) and ratios:

Pure balance sheet and pure income statement ratios will be the same. If the foreign currency is depreciating, translated mixed ratios (with an income statement item in the numerator and an end of period balance sheet item in the denominator) will be larger than the original ratio. If the foreign currency is appreciating, translated mixed ratios (with an income statement item in the numerator and an end of period balance sheet item in the denominator) will be smaller than the original ratio.

Comparing Results Using the Temporal Method and Current Rate Method

Now, let’s compare the results of the temporal method and current rate method as they relate to Vibrant’s 2022 balance sheet and income statement.

Figure 9.8: Comparison of Vibrant’s Balance Sheet and Income Statement Using the

Temporal Method and the Current Rate Method

Please note that this analysis assumes end of period balance sheet figures.

Analyzing the effect on the financial ratios of the choice of accounting method is a little more difficult in this case, but the basic procedure is as follows:

Determine whether the foreign currency is appreciating or depreciating.

Determine which rate (historical rate, average rate, or current rate) is used to convert the numerator under both methods. Determine whether the numerator of the ratio will be the same, larger, or smaller under the temporal method versus the current rate method. Determine which rate (historical rate, average rate, or current rate) is used to convert the denominator under both methods.

Determine whether the denominator of the ratio will be the same, larger, or smaller under the temporal method versus the current rate method.

Determine whether the ratio will increase, decrease, or stay the same based on the direction of change in the numerator and the denominator.

For example, let’s analyze the fixed asset turnover ratio, which is equal to revenue divided by fixed assets. Assume the foreign currency is depreciating.

The numerator (revenue) is converted at the same rate (the average rate) under both methods. The denominator (fixed assets) is converted at the historical rate under the temporal method and the current rate under the current rate method. If the foreign currency is depreciating, the historical rate will be higher than the current rate, which means fixed assets will be higher under the temporal method.

Since fixed assets are higher, turnover will be lower under the temporal method (higher denominator).