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}
    • Profit Margin
    • Indicates net profit generated by each dollar of sales.
    • Profit : margin = \frac{Profit}{Net : sales}

Liquidity Ratios

  • Measures short-term ability to pay maturing obligations and meet cash needs.
    • Current Ratio
    • Indicates how much current assets exceed current liabilities.
    • Rule of thumb: 1.5:1
    • Current : ratio = \frac{Current : assets}{Current : liabilities}

Solvency Ratios

  • Measures ability to survive long term.
    • Debt to Total Assets Ratio
    • Measures the percentage of assets financed by creditors.
    • Higher ratio = greater risk of being unable to pay debts.
    • Debt : to : total : assets : ratio = \frac{Total : liabilities}{Total : assets}

Gibbs Barber Shop Example

  • Calculating and interpreting ratios for Gibbs Barber Shop (profitability, liquidity, and solvency).
  • Return on Assets
    • Return : on : assets = \frac{Profit/Loss}{Average : total : assets}
  • Profit Margin
    • Profit : margin = \frac{Profit/Loss}{Net : sales}
  • Current Ratio
    • Current : ratio = \frac{Current : assets}{Current : liabilities}
  • Debt to Total Assets Ratio
    • Debt : to : total : assets : ratio = \frac{Total : liabilities}{Total : assets}$$