Analysis of Financial
The primary goal of financial management
is to maximize the stock price, not to
maximize accounting measures such as
net income or EPS.
However, accounting data do influence
stock prices, and to understand why a
company is performing the way it is and
to forecast where it is heading, one needs
to evaluate the accounting information
reported in the financial statements.
Financial statements report both on
a firm’s position at a point in time
and on its operations over some
past period. However, the real
value of financial statements lies in
the fact that they can be used to
help predict future earnings and
1. Liquidity Ratios
Liquid Asset : An asset that can be converted to cash
quickly without having to reduce the asset’s price
Current ratio : It indicates the extent to which
current liabilities are covered by those assets
expected to be converted to cash in the near
Quick (Acid Test) Ratio : The quick, or acid
test, ratio is calculated by deducting inventories
from current assets and then dividing the
remainder by current liabilities:
2. Asset Management
The second group of ratios, the asset management
ratios, measures how effectively the firm is
managing its assets.
a) Inventory Turnover Ratio : The inventory turnover
ratio is defined as sales divided by inventories.
b) Days Sales Outstanding (DSO) : indicates the average
length of time the firm must wait after making a sale
before it receives cash.
c) Fixed Assets Turnover Ratio : measures how
effectively the firm uses its plant and equipment.
d) Total Assets Turnover Ratio : measures the
turnover of all the firm’s assets.
3. Debt Management Ratios
a) Debt Ratio : measures the percentage of
funds provided by creditors.
b) Times-interest-earned (TIE) ratio :
measures the extent to which operating
income can decline before the firm is
unable to meet its annual interest costs.
c) EBITDA Coverage Ratio : A ratio whose
numerator includes all cash flows available
to meet fixed financial charges and whose
denominator includes all fixed financial
4. Profitability Ratios
a) The profit margin on sales : calculated by dividing
net income by sales, gives the profit per dollar of
b) Basic earning power (BEP) : This ratio shows the
raw earning power of the firm’s assets, before the
influence of taxes and leverage, and it is useful for
comparing firms with different tax situations and
different degrees of financial leverage.
c) Return on Total Assets (ROA) : The ratio of net
income to total assets measures the return on
total assets (ROA) after interest and taxes.
d) Return on Common Equity (ROE) : The ratio of
net income to common equity; measures the rate
of return on common stockholders’ investment.
5. Market Value Ratios
a) Price/Earnings Ratio : The ratio of the
price per share to earnings per share;
shows the dollar amount investors will
pay for $1 of current earnings.
b) Price/Cash Flow Ratio : The ratio of
price per share divided by cash flow per
share; shows the dollar amount
investors will pay for $1 of cash flow.
c) Market/Book (M/B) Ratio : The ratio of
a stock’s market price to its book value.
An analysis of a firm’s financial ratios
over time; used to estimate the likelihood
of improvement or deterioration in its
THE DU PONT CHART AND
Du Pont Chart : A chart designed to show
the relationships among return on
investment, asset turnover, profit margin,
Du Pont Equation : A formula which
shows that the rate of return on assets
can be found as the product of the profit
margin times the total assets turnover.
COMPARATIVE RATIOS and
Ratio analysis involves comparisons
— a company’s ratios are compared
with those of other firms in the
same industry, that is, to industry
USES AND LIMITATIONS of RATIO
Many large firms operate different divisions in different
industries, and for such companies it is difficult to
develop a meaningful set of industry averages.
Most firms want to be better than average, so merely
attaining average performance is not necessarily good.
Inflation may have badly distorted firms’ balance sheets—
recorded values are often substantially different from
“true” values. judgment.
Seasonal factors can also distort a ratio analysis.
Firms can employ “window dressing” techniques
to make their financial statements look stronger.
Different accounting practices can distort
It is difficult to generalize about whether a
particular ratio is “good” or “bad.”
A firm may have some ratios that look “good” and
others that look “bad,” making it difficult to tell
whether the company is, on balance, strong or
LOOKING BEYOND THE
Are the company’s
revenues tied to one
To what extent are the
tied to one key
To what extent does
the company rely on a
What percentage of the
company’s business is
lowers prices and profit
Future prospects. Does
the company invest
heavily in research and
Legal and regulatory
in laws and regulations
implications for many