Financial Ratios

Ratio Analysis

Financial statements provide information about a firm’s position at a specific point in time, as well as its operations over some past period. Nevertheless, the real value of financial statements lies in the fact that they can be used to help predict the firm’s financial position in the future, and to determine expected earnings and dividends. From an investor’s standpoint, predicting the future is the purpose of financial statement analysis; from management’s standpoint, financial statement analysis is useful both as a way to anticipate future conditions and, more importantly, as a starting point for planning actions that will influence the future course of events.

The first step in a financial analysis usually includes an evaluation of the firm’s ratios, which are designed to show relationships between financial statement ac- counts within firms and between firms. Translating ac- counting numbers into relative values, or ratios, allows us to compare the financial position of one firm with the financial position of another firm, even if their sizes are significantly different.

A positive number in the retained earnings account indicates only that in

the past, according to generally accepted accounting principles, the firm has earned income, but its dividends have been less than its reported income. Even though a company reports record earnings and shows an increase in the retained earnings account, it still might be short of cash. The same situation holds for individuals. You might own a new BMW (no loan), lots of clothes, and an expensive sound system and, therefore, have a high net worth. If you had only $0.23 in your pocket plus $5.00 in your checking account, you would still be short of cash.

Advantages

Converting financial accounting data into ratios allows for comparisons of companies to be made in spite of size. Ratios provide information that raw data cannot. Very large companies can be compared reliably to smaller companies. Using ratio analysis, companies can be evaluated even across industries. Trends of growth, increased performance, and deterioration within the firm can be evaluated against itself, as well as across the industry.

Limitations

While ratio analysis is valuable, there are limitations in application. All formulas are only as good at the input data. The ratios are calculated based on accounting data provided by the company, and while generally deemed reliable, accounting procedures may differ, or data may not be as reliable as another firm’s data. Also, when comparing past rates, for example, inflation may skew interpretations. In addition, formulas or equations for ratio analysis must be comparable for a true comparison, and therefore based on an industry standard.

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