Sophomore-Junior Diagnostic Project
Ratio Analysis

[Print Version]

Financial analysts use various techniques when analyzing financial statement information. For instance, horizontal analysis and vertical analysis of financial statements allow financial statement users to compare year-to-year financial position, results of operations, and cash flows. The most common way of comparing accounting numbers to evaluate the performance and risk of a firm is ratio analysis. The formulas are provided for each of the following types of ratios and some technical issues are also discussed:

• Liquidity Ratios: Measure the firm’s ability to meet short-term obligations as they come due.

• Financing Ratios: Provide some indication of the riskiness of a company with regard to its ability to pay its long-term debts.

• Activity Ratios: Measure a company’s efficiency in managing its assets.

• Profitability Ratios: Assist in evaluating a company’s profit-making activities.

• Stock Ratios: These ratios can be used to analyze share price.

• Technical issues concerning ratio computation

The usual procedure in performing ratio analysis is to (1) compute financial ratios for the firm, using financial statements from the last few years, (2) compare trends in key financial ratios for the firm, and (3) compare the firm’s financial ratios to industry averages. However, ratio analysis should not be taken in isolation of other aspects of a business. Ratios must be seen against norms/benchmarks for the industry, the previous year’s performance, the company’s environment, and the expectations of significant stakeholders.  The interpretation of changes in ratios from year to year can be profoundly affected by three factors: (1) changes in a company’s accounting policies, (2) published accounting data that is dressed up so as to produce more favorable outcomes, and (3) the flexibility offered GAAP that can affect the relevance of industry benchmarks.

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