## Selected Financial Ratios and Analyses

This section presents financial ratios and their analysis. Why are financial ratios and their analysis important? To answer this question, you should pay particular attention to the firm's profitability, and allow comparisons between the firm and its industry. By the end of this section, you will be able to summarize how an interested party would use financial ratios to analyze a company's financial statement.

Financial ratios and their analysis provide information on a firm's profitability and allow comparisons between the firm and its industry.

#### LEARNING OBJECTIVE

• Summarize how an interested party would use financial ratios to analyze a company's financial statement

#### KEY POINTS

• When using comparative financial statements, the calculation of dollar or percentage changes in the statement items or totals from one period to the next or for the timeframe presented is referred to as horizontal analysis.
• Vertical analysis performed on an income statement is especially helpful in analyzing the relationships between revenue and expense items, such as the percentage of cost of goods sold to sales.
• Financial ratios, which compare one value in relation to another value over a 12 month period, are computed using information from a company's financial statements. Ratios can identify various financial attributes, such as solvency and liquidity, profitability, and return on equity.
• An example of a financial ratio is the current ratio, used to determine a company's liquidity, or its ability to meet its short term obligations. When comparing two companies, in theory, the entity with the higher current ratio is more liquid than the other.
• Often a financial ratio, which is a relative magnitude of two selected numerical values taken from a company's financial statements is used to find out a specific piece of information such as the quality of income.

#### TERMS

• solvency

The state of having enough funds or liquid assets to pay all of one's debts; the state of being solvent.

• trend

an inclination in a particular direction

• comparative

Comparable; bearing comparison.

#### Analyzing the Financial Statements

Analyzing a company's financial statements allows interested parties (investors,creditors and company management) to get an overall picture of the financial condition and profitability of a company. There are several ways to analyze a company's financial statements.

#### Horizontal vs. Vertical Analysis

Two main methods for analysis are horizontal and vertical analysis. When using comparative financial statements, the calculation of dollar or percentage changes in the statement items or totals over time is horizontal analysis. This analysis detects changes in a company's performance and highlights trends.

Vertical analysis is usually performed on a single financial statement (i.e., income statement): each item is expressed as a percentage of a significant total. Vertical analysis performed on an income statement is especially helpful in analyzing the relationships between revenue and expense items, such as the percentage of cost of goods sold to sales.

The Balance Sheet: If an error is found on a previous year's financial statement, a correction must be made and the financials reissued.

#### Using Ratios

Financial ratios, which compare one value in relation to another value over a 12 month period, are computed using information from a company's financial statements. Ratios can identify various financial attributes of a company, such as solvency and liquidity, profitability (quality of income), and return on equity. A company's financial ratios can also be compared to those of their competitors to determine how the company is performing in relation to the rest of the industry.

Financial ratios may be used by managers within a firm, by current and potentialshareholders (owners), and by a firm's creditors. For example, financial analysts compute financial ratios of public companies to evaluate their strengths and weaknesses and to identify which companies are profitable investments and which are not. Changes in financial ratios can impact a public company's stock price, depending on the effect the change has on the business. A publicly traded company's stock price can also be a variable used in the computation of certain ratios, such as the price/earnings ratio.

#### Examples of Ratios

The following are some examples of financial ratios that are used to analyze a company. For example, the quality of income ratio is computed by dividing cash flowfrom operating activities (CFOA) by net income:

Quality of income = CFOA / Net income

This ratio indicates the proportion of income that has been realized in cash. As with quality of sales, high levels for this ratio are desirable. The quality of income ratio has a tendency to exceed 100% because depreciation expense decreases net income and cash outflows to replace operating assets (part of cash flow from investing activities) is not subtracted when calculating the numerator.

Capital Acquisition Ratio = (cash flow from operations - dividends) / cash paid for acquisitions.

The capital acquisition ratio reflects the company's ability to finance capital expenditures from internal sources. A ratio of less than 1:1 (100 %) indicates that capital acquisitions are draining more cash from the business than they are generating revenues.

Current Ratio = Current Assets/Current Liabilities

The current ratio is used to determine a company's liquidity, or its ability to meet its short term obligations. When comparing two companies, in theory, the entity with the higher current ratio is more liquid than the other. However, it is important to note that determination of a company's solvency is based on various factors and not just the value of the current ratio.

Source: Boundless