Chapter II




Ratio Analysis

Financial Statements

The Income Statement (financial summary of the firm ‘s operating result during a specified period)

The Balance Sheet (summary statement of the firm ‘s financial position at a given point in time)

The Statement of Cash Flows (summary of the cash flows over a specified period)

The Statement of Retained Earnings (reconciles the net income during a year, and any dividends paid, with the change in retained earnings between the start and the endof that year)

The Income Statement

- Provides a financial summary of the firm ‘s operating result during a specified period.

- Most common are income statements covering a 1-year period ending December

31. Monthly statements are prepared for use by management. Quaterly statements must be made available to the stockholders of publicly owned corporations.

The Income Statement

General form:


-Cost of goods sold

= Gross profit

-Operating expenses

= Operating profit (EBIT)

-Financial cost

= Earning Before Taxes (EBT)


= Earning After Taxes (EAT)

The Balance Sheet

- Balances the firm ‘s assets against its financing (debt or equity)

- Short-term x Long-term assets and liabilities

Shotr-term (current assets and liabilities) – they are expected to be converted into cash or paid within 1 year or less.

Long-term (fixed assets, equity, long term debt)

– they are expected to remain on the firm‘s books far more than 1 year.

The Balance Sheet

As is customary, the assets are listed from the most liquid (cash) down to the least liquid.


Current assets

Fixed assets

Liabilities and Equity

Current liabilities

Long term debt / liabilities


The Statement of Cash Flows

• Analyses the firm’s ability to generate cash and cash equivalents

• Statement of CF shows:

– Where did the cash come from?

– What was it used for?

– What was the change in the cash balance?

• Operating, Investing and Financing activities

• Sources vs. Usage of funds

Financial Analysis

- Evaluation of firm ’s performance

- Users: investors, stockholders, management, creditors, business partners

- Types of Ratio Comparisons

- Cross-Sectional Analysis (benchmarking)

- Time-Series Analysis

- Combined Analysis

Categories of Financial Ratios:

Liquidity ratios

Activity ratios

Debt ratios

Profitability ratios

Market ratios

Liquidity Ratios

Measure the ability of a firm to satisfy its short-term obligations.

Current Ratio = Current Assets / Current Liabilities

(acceptable = 2, depends on industry)

Quick Ratio = (Current Assets – Inventory) /

Current Liabilities

(acceptable = 1, depends on industry)

Activity Ratios

Measure the speed with which various accounts are converted into sales or cash.

Inventory Turnover = Cost of Goods Sold / Inventory

Average Collection Period = Accounts receivable /

(Annual sales/365)

Average Payment Period = Accounts payable /

(Annual purchases/365)

Total Assets Turnover = Sales / Total Assets

Debt Ratios measure how much of the firm is financed with other people’s money and the firm’s ability to meet fixed charges.

Debt Ratio = Total Liabilities / Total Assets

Interest Coverage Ratio or Times Interest Earned =

EBIT / Interest

Profitability Ratios measure a firm’s return with respect to sales, assets, or equity.

Common-size Income Statement – each item is expressed as % of sales.

Gross Profit Margin = Gross Profit / Sales

Operating Profit Margin = EBIT / Sales

EPS = Earnings available for comm. Stockh. / number of shares

ROA = Earnings available for comm. Stockh. / Total


ROE = Earnings available for comm. Stockh. /

Common stock Equity

Market Ratios insight into how well investors in the marketplace feel the firm is doing in terms of return and risk.

PE = Market price per share / EPS

Market/Book Ratio = Market price per share / Book value per share

Book value per share = Equity / Number of shares


Thank You for Your attention.