RATIO ANALYSIS

• Short term creditors - primarily interested in the liquidity of a company
• Characteristic generally evaluated in analyzing financial statements:

  • Liquidity
  • Profitability
  • Solvency
• In analyzing the financial statements of a company, a single item on the financial statements is more meaningful if compared to other financial information.
• Short-term creditors are usually most interested in evaluating liquidity.
• Long-term creditors are usually most interested in evaluating profitability and solvency.
• Shareholders are most interested in evaluating profitability and solvency.
• A shareholder is interested in the ability of a firm to:

  • pay consistent dividends
  • appreciate in share price
  • survive over a long period
• Comparisons of financial data made within a company are called intracompany comparison
• A technique for evaluating financial statements that expresses the relationship among selected items of financial statement data is ratio analysis
• Tools used in financial statement analysis:

  • Horizontal analysis
  • Ratio analysis
  • Vertical analysis
• In analyzing financial statements, horizontal analysis is a tool.
• Horizontal analysis is also called trend analysis.
• Vertical analysis is also known as common size analysis.
• In ratio analysis, the ratios are never expressed as a variable.
• The formula for horizontal analysis of changes since the base period is the current year amount is minus the base year amount divided by the base year amount
• Horizontal analysis evaluates a series of financial statement data over a period of time to determine the amount and/or percentage increase or decrease that has taken place.
• Horizontal analysis evaluates financial statement data over a period of time.
• Comparative statements of financial position are usually prepared for two years.
• Horizontal analysis is appropriately performed on all three of the major financial statements.
• A horizontal analysis performed on a statement of retained earnings would not show a percentage change in expenses.
• Under which of the following cases may a percentage change be computed?

  The trend of the balances is decreasing but all balances are positive.
• Vertical analysis is a technique which expresses each item within a financial statement in terms of a percent of a base amount.
• In common size analysis, a base amount is required.
• In performing a vertical analysis, the base for prepaid expenses is total assets.
• In performing a vertical analysis, the base for sales revenue on the income statement is net sales
• In performing a vertical analysis, the base for sales returns and allowances is net sales.
• Liquidity ratios:

  • Acid test ratio
  • Current ratio
  • Inventory turnover
• A ratio calculated in the analysis of financial statements expresses a mathematical relationship between two numbers.
• A liquidity ratio measures the short-term ability of the enterprise to pay its maturing obligations and to meet unexpected needs for cash.
• The current ratio is used to evaluate a company's liquidity and short-term debt paying ability.
• The acid-test (quick) ratio relates cash, short-term investments, and net receivables to current liabilities
• Included in computing ACID TEST RATIO:

  • Cash
  • Inventory
  • Receivables
  • Current Liabilities
• Asset turnover measures how efficiently a company uses its assets to generate sales.
• Profit margin is calculated by dividing net income by sales.
• The debt to total assets ratio measures the percentage of the total assets provided by creditors.
• Trading on the equity (leverage) refers to the use of borrowed money to increase the return to owners.
• The current ratio may also be referred to as the working capital ratio.
• A weakness of the current ratio is that it doesn't take into account the composition of the current assets.
• A supplier to a company would be most interested in the company’s current ratio.
• Ratios are used as tools in financial analysis because they may provide information that is not apparent from inspection of the individual components of the ratio