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Ratio Analysis

Ratio analysis is a particular type of financial statement analysis where the relationship between two or more items from the financial statements is analyzed.

A particular ratio might include information from various sources, including information not typically contained in the financial statements, such as market price of a stock.

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Objectives of Creditors

Short-term creditors, both “trade” creditors and “lending institutions,” are primarily concerned with the firm’s ability to pay its bills in a timely fashion.

Long-term creditors are concerned with the firm’s long-term ability to repay any loan amounts as well as the interest on that debt.

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Investors are concerned with many things, but probably the most important consideration is the company’s ability to generate income in the future.

Profitable operations for the company usually translate into dividends and stock price appreciation for the investors.

Objectives of Equity Investors

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Members of management have the respon-sibility of leading the firm through the day-to-day activities. The results of these activities are reflected in the financial statements.

Thus, management has two main concerns regarding financial statement analysis: – 1) to present the information in the most favorable

light, and – 2) to monitor the overall performance.

Objectives of Management

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Measuring Profitability

Profitability refers to the company’s ability to generate income. Profitability ratios are used to measure a firm’s past performance and to aid in the prediction of future profits.

Most business people agree that long-term profits are more important than short-term profits, yet most of the commonly used ratios focus on short-term profitability.

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Profit Margin After Income Tax Ratio

Net income after taxesSales

Use after-tax income instead of before-tax. Some people argue that since taxes are a “normal” expense that is incurred, the effect of income taxes should be included.

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Return on Equity Ratio

Net income after taxes Equity

This ratio measures the profitability on the amount of investment by the company owners rather than the total investment in assets.

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Measuring Liquidity

Liquidity refers to the company’s ability to generate cash as needed to pay its short-term obligations.

Short-term creditors (current and potential) are particularly concerned with a company’s liquidity measures.

Liquidity measures focus on the “liquidity of the assets” available to the company.

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Current Ratio

Current assets Current liabilities

This ratio is a comparison of the level of current assets available to pay the current liabilities. This is a very widely used ratio.

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Quick Ratio

Cash + M/S + A/R

Current liabilities

Also called the “acid-test ratio,” this is a more stringent measure of liquidity. The focus is placed on the “quick assets,” those that can be quickly turned into cash.

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Receivables Turnover Ratio

Sales Accounts receivable

A measurement of how quickly a company collects their accounts receivable. The higher the turnover, the more quickly the receivables are being collected.

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Measuring Solvency

Solvency refers to the ability to meet long-term obligations resulting from debt.

These measurements are similar to the liquidity measures, except the focus is on all assets and liabilities rather than the current assets and liabilities.

These measures are of interest to long-term creditors, stockholders, and management.

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Debt Ratio

Total liabilities Total assets

Measures the percentage of a company’s assets that is financed by debt, rather than equity. Debt % + Equity % = 100%

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Coverage Ratio

Earnings before interest

Interest expense Also called the “times interest earned

ratio.” An indication of the company’s ability to make interest payments.

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Using the Ratios

After calculating the ratios for a particular company, you might want to do some or all of the following:– Compare ratios to industry averages,– Look for company trends,– Consider the industry environment, and– Draw conclusions