Financial Statement Analysis: Ratios

Interpreting Financial Statements

Overview

  • Analyse financial statements by calculating and interpreting ratios.
    • Profitability
    • Liquidity
    • Solvency

Why Analyse Financial Statements?

  • $ amounts in isolation are of limited use.
  • Relationships between financial statement items are important for comparisons.

How to Analyse Financial Statements

  • Ratio analysis: shows relationships among items.
  • A ratio: mathematical relationship between two quantities.
    • Expressed as percentages, rates, or proportions.

Types of Ratios

  • Profitability ratios
    • Return on assets
    • Profit margin
  • Liquidity ratios
    • Current ratio
  • Solvency ratios
    • Debt to total assets ratio

Profitability Ratios

  • Measure operating success.
    • Return on Assets
    • Indicates net profit generated by each dollar invested in assets.
    • Return on assets = \frac{Profit}{Average : total : assets}</li><li>ProfitMargin</li><li>Indicatesnetprofitgeneratedbyeachdollarofsales.</li><li></li> <li>Profit Margin</li> <li>Indicates net profit generated by each dollar of sales.</li> <li>Profit : margin = \frac{Profit}{Net : sales}</li></ul></li></ul><h4id="liquidityratios">LiquidityRatios</h4><ul><li>Measuresshort−termabilitytopaymaturingobligationsandmeetcashneeds.<ul><li>CurrentRatio</li><li>Indicateshowmuchcurrentassetsexceedcurrentliabilities.</li><li>Ruleofthumb:1.5:1</li><li></li></ul></li> </ul> <h4 id="liquidityratios">Liquidity Ratios</h4> <ul> <li>Measures short-term ability to pay maturing obligations and meet cash needs.<ul> <li>Current Ratio</li> <li>Indicates how much current assets exceed current liabilities.</li> <li>Rule of thumb: 1.5:1</li> <li>Current : ratio = \frac{Current : assets}{Current : liabilities}</li></ul></li></ul><h4id="solvencyratios">SolvencyRatios</h4><ul><li>Measuresabilitytosurvivelongterm.<ul><li>DebttoTotalAssetsRatio</li><li>Measuresthepercentageofassetsfinancedbycreditors.</li><li>Higherratio=greaterriskofbeingunabletopaydebts.</li><li></li></ul></li> </ul> <h4 id="solvencyratios">Solvency Ratios</h4> <ul> <li>Measures ability to survive long term.<ul> <li>Debt to Total Assets Ratio</li> <li>Measures the percentage of assets financed by creditors.</li> <li>Higher ratio = greater risk of being unable to pay debts.</li> <li>Debt : to : total : assets : ratio = \frac{Total : liabilities}{Total : assets}</li></ul></li></ul><h4id="gibbsbarbershopexample">GibbsBarberShopExample</h4><ul><li>CalculatingandinterpretingratiosforGibbsBarberShop(profitability,liquidity,andsolvency).</li><li>ReturnonAssets<ul><li></li></ul></li> </ul> <h4 id="gibbsbarbershopexample">Gibbs Barber Shop Example</h4> <ul> <li>Calculating and interpreting ratios for Gibbs Barber Shop (profitability, liquidity, and solvency).</li> <li>Return on Assets<ul> <li>Return : on : assets = \frac{Profit/Loss}{Average : total : assets}</li></ul></li><li>ProfitMargin<ul><li></li></ul></li> <li>Profit Margin<ul> <li>Profit : margin = \frac{Profit/Loss}{Net : sales}</li></ul></li><li>CurrentRatio<ul><li></li></ul></li> <li>Current Ratio<ul> <li>Current : ratio = \frac{Current : assets}{Current : liabilities}</li></ul></li><li>DebttoTotalAssetsRatio<ul><li></li></ul></li> <li>Debt to Total Assets Ratio<ul> <li>Debt : to : total : assets : ratio = \frac{Total : liabilities}{Total : assets}$$