15-5a Financial Ratios

Reality Che C k lO-4

English historian Lord Acton is famous for his quote: “Power tends to corrupt, and absolute power corrupts absolutely.” In a country with no checks and balances on the power of government officials, do you think citizens are more concerned about corruption there than in a country like the United States, which has a checks and balance system? If there were no audits of financial statements of publicly traded companies, do you think stockholders would be concerned about the accuracy and reliability of those statements?

15-5 Financial Statement Analysis

Financial statement analysis is an evaluation of the financial statements to identify significant trends or relationships among the items contained within them. For example, financial ratios are often used to identify important relationships. Financial statement analysis begins with the information directly provided on the financial statements and builds upon that information to provide a more comprehensive understanding of a company’s financial situation. On the surface, financial statements can provide answers to key questions asked by management, investors, lenders, and other parties interested in a firm’s performance. For example, the income statement answers the question: How much did the firm earn or lose from operations during the period? However, while it may be useful to know how much a company earned or lost, this may not be sufficient information by itself to determine whether to invest in the company or loan money to it.

Financial statement analysis goes beyond the surface details. For example, a trend analysis of net income would examine how net income has changed from year to year for the past five or ten years. Another analysis of net income would compare it to sales revenue; net income divided by sales revenue equals profit margin. Investors and other financial statement users may be interested in whether profit margin is increasing or decreasing. An investor may be interested in how one company’s profit margin compares to another company’s profit margin.

15-5a Financial Ratios

A financial ratio shows the relationship of one number on a financial statement to another number. Financial ratios are designed to assess different aspects of the firm’s financial situation. Financial ratios enable meaningful comparisons among companies of different sizes to assess which companies are performing better and which are performing worse. For example, when comparing two companies, the total dollar amount of debt is less important than the ratio of total debt to total assets. The debt ratio is calculated as follows:

Debt Ratio= Total Liabilities Total Assets

The company with the most debt may be in better financial condition because it has proportionately much more in total assets. A company with a $10 million in debt may be better than another company with only $5 million in debt. What if the company with $10 million in debt also has $50 million in total assets and the company with $5 million in debt also has $5 million in assets? The first company has a debt ratio of 0.20 ($10 million/$50 million) and the second company has a debt ratio of 1.00 ($5 million/$5 million). Financial ratios equalize companies of different sizes for comparison of financial performance.

LO-5

Explain how financial statement analysis can be used to evaluate a company’s financial situation and compare it to other companies.

financial statement analysis

an evaluation of a company’s financial statements in order to identify significant trends or relationships among the items

financial ratio

the relationship of a number on the financial statements to another number