Financial Statement Analysis - Ratio Analysis

Financial analysts commonly use financial ratios to evaluate the investment worthiness of a company’s equity or debt.  Ratio analysis is commonly done in comparison to other companies of similar industry.

When analyzing financial ratios, the analyst should consider the values in the context of the business cycle, trends, and industry or competitor standards.

5 Ratio Categories

Activity Ratios

Activity ratios measure the efficiency in which management runs the company.

Activity Ratio Examples: Receivables turnover, inventory turnover, payables turnover, fixed asset turnover, and total asset turnover.

Liquidity Ratios

Measure the company’s capacity to meet its short-term financial commitments.

Liquidity Ratio Examples: quick ratio (also called acid test ratio), cash ratio, defensive interval ratio, and cash conversion cycle.

Solvency Ratios

Solvency ratios measure the company’s capacity to fulfill long-term financial commitments.

Solvency Ratio Examples: Debt to assets ratio (also called total debt ratio), debt to capital ratio, debt to equity ratio, financial leverage ratio, interest coverage ratio (also called times interest earned ratio), and fixed financial charge ratio.

Profitability Ratios

Measure the company’s management effectiveness in driving earnings from sales and/or assets.

Profitability Ratio Examples: gross margin, operating margin, pre-tax margin, net profit margin, operating return on assets, return on assets, return on total capital, return on equity.

ROE note: CFAI emphasizes that candidates understand the DuPont model for ROE, which provides insights into the different levers driving a firm’s profitability.