The Analysis of Financial Statements
Financial ratios are often thought of as being useful to:
1. Managerstohelpruntheirbusiness
2. Bankersorotherlendersforcreditanalysis
3. Stockholders(orpotentialinvestors)forinvestmentdecision-making.
Liquidity Ratios
There are two primary liquidity ratios:
1. Current ratio:
2. Quick ratio:
In general, the higher the current and quick ratios, the greater the liquidity (also known as
solvency) of the firm.
Analysis: Sometimes standard liquidity ratios (current ratio and quick ratio) are considered
deficient as a true measure of a firm's liquidity. This is generally the case because true
liquidity depends on the timing of cash inflows versus cash outflows, and account levels
do not accurately depict this timing dimension. For that reason it may be better to regard
the current and quick ratios as solvency ratios—the ability to meet short-term obligations.
Asset Management Ratios
1. Inventory turnover ratio:
2. Days sales outstanding:
3. Fixed asset turnover ratio:
4. Total asset turnover ratio:
Asset management ratios, specifically the inventory turnover ratio, the fixed asset
turnover ratio, and the total asset turnover ratio provide insight into how efficiently (or
effectively) the firm’s managers are utilizing the company’s asset base. Generally
speaking, high turnover ratios mean the company is being run more efficiently.
Sometimes this is called a “lean and mean” approach to asset management. However, in
the case of days sales outstanding, a higher value indicates the firm has too much
invested in receivables, which means uncollected credit sales, thereby reducing liquidity.
Analysis: While high turnover ratios can lead to lower cost and increased profitability, a
“lean and mean” asset management policy leads to greater risk.
Debt Management Ratios
1. Debt ratio:
(Debt ratio instead)
2. Times-interest-earned ratio (EBIT - Earnings before interest and taxes):
3. EBITDA (Earnings before interest, taxes, depreciation and amortization)
coverage ratio:
In the case of the debt ratio, a higher value means the firm relies on debt instruments
(bonds or loans) to finance its asset base. Although debt itself is not necessarily bad (it
can indeed increase or “leverage up” return to shareholders), it does represent a claim
on the future cash flows of the firm and therefore increases risk. The times-interestearned and EBITDA coverage ratios indicate the “strength” of a firm or its ability to meet
debt obligations.
Creditors regard higher values of these ratios as positive.
Analysis: As with individual households, a firm which carries a substantial amount of debt
has contractual obligations to creditors. These obligations increase risk and may increase
the likelihood of default or bankruptcy. In addition, a high debt ratio may restrict the ability
to borrow in the future, thereby reducing the financial flexibility of the firm.
Profitability Ratios
1. Profit margin on sales:
2. Basic earning power ratio:
3. Return on total assets:
4. Return on common equity:
A high profit margin is positive, and suggests aggressive expense control. A high BEP
ratio is also regarded as a positive indicator. BEP is a broad measure of the firm’s the
profitability of assets. It also reflects profitability before the impact of leverage and taxation
is captured. ROA is another broad measure of a firm’s profitability and a high ROA is a
positive sign. Finally, ROE indicates the return on stockholder invested funds and is of
prime importance to shareholders. A high ROE is attractive to shareholders.
Analysis: Profitability ratios often reflect the results, or conditions, seen in the first three
major categories of ratios for a firm; liquidity, asset management, and debt management
ratios. This is because the first three categories of ratios largely reflect strategic
management decisions. These decisions often have direct impact on the firm’s revenue,
cost conditions, and profitability.
Market Value Ratios
1. Price/earnings ratio:
2. Price/cash flow ratio:
3. Market/book ratio:
In general, higher P/E ratios are seen as a positive sign. Other things held constant, a
high P/E ratio indicates a positive outlook on the part of investors with respect to the firm’s
future profitability. A high P/CF ratio is also seen as positive by investors, and in some
industries reflects well on expected future dividends. Finally, a high M/BV ratio indicates
positive expectations on the future performance of a company.
Analysis: Market value ratios reflect what “outsiders” think about company performance.
Highly profitable, well-managed companies positioned in high growth industries often
have high market values. High valuations (whether it be high stock price or high priceearnings ratios) reflect the optimistic outlook which investors have for the company.