Introduction to Financial Ratios
When computing financial ratios and when doing other financial statement analysis always keep
in mind that the financial statements reflect the accounting principles. This means assets are
generally not reported at their current value. It is also likely that many brand names and unique
product lines will not be included among the assets reported on the balance sheet, even though
they may be the most valuable of all the items owned by a company.
These examples are signals that financial ratios and financial statement analysis have limitations.
It is also important to realize that an impressive financial ratio in one industry might be viewed as
less than impressive in a different industry.
Our explanation of financial ratios and financial statement analysis is organized as follows:
Balance Sheet
o General discussion
o
Common-size balance sheet
Financial ratios based on the balance sheet
Income Statement
o General discussion
o
Common-size income statement
Financial ratios based on the income statement
Statement of Cash Flows
Note: To assist you in understanding financial ratios, we developed business forms for
computing 24 popular financial ratios. They are included in AccountingCoach PRO.
General Discussion of Balance Sheet
The balance sheet reports a company's assets, liabilities, and stockholders' equity as of a
specific date, such as December 31, 2014, March 31, 2014, etc.
The accountants' cost principle and the monetary unit assumption will limit the assets
reported on the balance sheet. Assets will be reported
(1) only if they were acquired in a transaction, and
(2) generally at an amount that is not greater than the asset's cost at the time of the transaction.
This means that a company's creative and effective management team will not be listed as an
asset. Similarly, a company's outstanding reputation, its unique product lines, and brand names
developed within the company will not be reported on the balance sheet. As you may surmise,
these items are often the most valuable of all the things owned by the company. (Brand names
purchased from another company will be recorded in the company's accounting records at their
cost.)
The accountants' matching principle will result in assets such as buildings, equipment,
furnishings, fixtures, vehicles, etc. being reported at amounts less than cost. The reason is these
assets are depreciated. Depreciation reduces an asset's book value each year and the
amount of the reduction is reported as Depreciation Expense on the income statement.
While depreciation is reducing the book value of certain assets over their useful lives, the
current value (or fair market value) of these assets may actually be increasing. (It is also possible
that the current value of some assetssuch as computersmay be decreasing faster than the
book value.)
Current assets such as Cash, Accounts Receivable, Inventory, Supplies, Prepaid Insurance,
etc. usually have current values that are close to the amounts reported on the balance sheet.
Current liabilities such as Notes Payable (due within one year), Accounts Payable, Wages
Payable, Interest Payable, Unearned Revenues, etc. are also likely to have current values that
are close to the amounts reported on the balance sheet.
Long-term liabilities such as Notes Payable (not due within one year) or Bonds Payable (not
maturing within one year) will often have current values that differ from the amounts reported on
the balance sheet.
Stockholders' equity is the book value of the company. It is the difference between the
reported amount of assets and the reported amount of liabilities. For the reasons mentioned
above, the reported amount of stockholders' equity will therefore be different from the current or
market value of the company.
By definition the current assets and current liabilities are "turning over" at least once per year. As
a result, the reported amounts are likely to be similar to their current value. The long-term assets
and long-term liabilities arenot "turning over" often. Therefore, the amounts reported for longterm assets and long-term liabilities will likely be different from the current value of those items.
The remainder of our explanation of financial ratios and financial statement analysis will use
information from the following balance sheet:
To learn more about the balance sheet, go to:
Explanation of Balance Sheet
Quiz for Balance Sheet
Crossword Puzzles for Balance Sheet
Common-Size Balance Sheet
One technique in financial statement analysis is known as vertical analysis. Vertical analysis
results in common-size financial statements. A common-size balance sheet is a balance sheet
where every dollar amount has been restated to be a percentage of total assets. We will illustrate
this by taking Example Company's balance sheet (shown above) and divide each item by the
total asset amount $770,000. The result is the following common-size balance sheet for Example
Company:
The benefit of a common-size balance sheet is that an item can be compared to a similar item of
another company regardless of the size of the companies. A company can also compare its
percentages to the industry's average percentages. For example, a company with Inventory at
4.0% of total assets can look to its industry statistics to see if its percentage is reasonable.
(Industry percentages might be available from an industry association, library reference desks,
and from bankers. Many banks have memberships in Risk Management Association (RMA), an
organization that collects and distributes statistics by industry.) A common-size balance sheet
also allows two businesspersons to compare the magnitude of a balance sheet item without
either one revealing the actual dollar amounts.
Financial Ratios Based on the
Balance Sheet
Financial statement analysis includes financial ratios. Here are three financial ratios that are
based solely on current asset and current liability amounts appearing on a company's balance
sheet:
Four financial ratios relate balance sheet amounts for Accounts Receivable and Inventory to
income statement amounts. To illustrate these financial ratios we will use the following income
statement information:
To learn more about the income statement, go to:
Explanation of Income Statement
Quiz for Income Statement
Crossword Puzzle for Income Statement
The next financial ratio involves the relationship between two amounts from the balance sheet:
total liabilities and total stockholders' equity:
General Discussion of Income
Statement
The income statement has some limitations since it reflects accounting principles. For example, a
company's depreciation expense is based on the cost of the assets it has acquired and is using
in its business. The resulting depreciation expense may not be a good indicator of the economic
value of the asset being used up. To illustrate this point let's assume that a company's buildings
and equipment have been fully depreciated and therefore there will be no depreciation expense
for those buildings and equipment on its income statement. Is zero expense a good indicator of
the cost of using those buildings and equipment? Compare that situation to a company with new
buildings and equipment where there will be large amounts of depreciation expense.
The remainder of our explanation of financial ratios and financial statement analysis will use
information from the following income statement:
To learn more about the income statement, go to:
Explanation of Income Statement
Quiz for Income Statement
Crossword Puzzle for Income Statement
Common-Size Income Statement
Financial statement analysis includes a technique known as vertical analysis. Vertical analysis
results in common-size financial statements. A common-size income statement presents all of
the income statement amounts as a percentage of net sales. Below is Example Corporation's
common-size income statement after each item from the income statement above was divided by
the net sales of $500,000:
The percentages shown for Example Corporation can be compared to other companies and to
the industry averages. Industry averages can be obtained from trade associations, bankers, and
library reference desks. If a company competes with a company whose stock is publicly traded,
another source of information is that company's "Management's Discussion and Analysis of
Financial Condition and Results of Operations" contained in its annual report to the Securities
and Exchange Commission (SEC). This annual report is the SEC Form 10-K and is usually
accessible under the "Investor Relations" tab on the corporation's website.
Financial Ratios Based on the Income
Statement
Statement of Cash Flows
The statement of cash flows is a relatively new financial statement in comparison to the income
statement or the balance sheet. This may explain why there are not as many well-established
.financial ratios associated with the statement of cash flows
We will use the following cash flow statement for Example Corporation to illustrate a limited
:financial statement analysis
The cash flow from operating activities section of the statement of cash flows is also used by
some analysts to assess the quality of a company's earnings. For a company's earnings to be of
"quality" the amount of cash flow from operating activities must be consistently greater than the
company's net income. The reason is that under accrual accounting, various estimates and
assumptions are made regarding both revenues and expenses. When it comes to cash, however,
.the money is either in the bank or it isn't
:To learn more about the statement of cash flows, go to
