financial ratio analysis

CHAPTER 3
ANALYSIS OF FINANCIAL
STATEMENTS
 R ATIO ANALYSIS
 LIQUIDITY
 ASSET MANAGEMENT
 DEBT MANAGEMENT
 PROFITABILITY
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FINANCIAL RATIO ANALYSIS
DEFINITION
 the calculation and comparison

of ratios which are derived from the information in a company's financial statements.

Why are ratios useful?
 Ratios standardize numbers and facilitate

comparisons.
 Ratios are used to highlight weaknesses and strengths.
 Ratio comparisons should be made through time and with competitors
Trend analysis
 Peer (or Industry) analysis


Ratio Comparisons
 Peer or Industry Analysis (Cross-sectional analysis) involves the comparison of different firms’ financial ratios at the same point in time; involves comparing the firm’s ratios to those other firms in its industry or to industry averages.  Trend Analysis (Time-series analysis) involves the

evaluation of the firm’s financial performance over time using financial ratios. Comparison of current to past performance, using ratio analysis, allows the firm to determine whether it is progressing as planned.

Potential problems and limitations of financial ratio analysis
 Comparison with industry averages is

difficult for a conglomerate firm that operates in many different divisions.
 “Average” performance is not necessarily good, perhaps the firm should aim higher.
 Seasonal factors can distort ratios.
 “Window dressing” techniques can make statements and ratios look better.

More issues regarding ratios
 Sometimes it is hard to tell if a ratio is “good”

or “bad”.
 Difficult to tell whether a company is, on balance, in strong or weak position.

What are the major categories of ratios, and what questions do they answer?
 Liquidity: Can we make required payments?
 Asset management: right amount of assets

vs. sales?

 Debt management: Right mix of debt and

equity?

 Profitability: Do sales prices exceed unit

costs, and are