More Descriptive

Ratio Analysis

 What is the purpose of analyzing ratios (rather than raw absolute numbers)?

 Ratios abstract from size. This enables cross-sectional and time-series comparisons to be made for firms of unequal size. The key assumption is that a given percentage change in the denominator of a ratio produces the same proportional change in the numerator. The same logic applies to common size statements.

 Ratios compare outputs to the inputs that are used to generate that output. For example, profitability ratios compare income to the equity used to generate that income.

 Ratio analysis highlights and measures attributes of the firm in a way that can help explain trends and forecast future results. Changes in some ratios may signal fundamental changes in the firm’s business environment.

 Is there a correct definition of a ratio? What makes a definition of a ratio "good"? The simplest answer is that a ratio is "good" if it represents and measures the attribute the user is trying to capture. The better a ratio represents and measures the attribute the user is trying to capture the better the ratio's definition.

 While there are numerous ratios, we will divide them into four groups: Activity, liquidity, long-term debt and solvency, and profitability.

 The activity ratios basically measure turnover, which is the firm’s ability to generate sales off its asset base.

 Liquidity ratios measure short-term cash-generating ability and the cash cycle, which is the length of time it takes for the cash outlay for inventory to be translated into a cash collection.

 Long-term debt and solvency ratios measure debt levels relative to equity, the firm’s ability to cover its interest obligations (interest coverage), CFO relative to capital expenditures, and CFO relative to debt. Interest coverage is defined in terms of accrual earnings or in terms of CFO.

 Profitability ratios measure the firm’s ability to generate income...