Chapter 6
Primary Ratios and Common Size Income Statement
I. Financial statement analysis is necessary because accounting numbers are not meaningful by themselves. They must be compared to a standard to become useful.
A. Time-series analysis compares the numbers across time and focuses on trends for a particular company.
B. Cross-sectional analysis compares the number of similar firms in the same industry for a particular time period.
II. Ratio Analysis
A. There is no magic set of ratios that all analysts use or one right way to calculate the ratios. The ratios we discuss are some of the most popular, but analysts make many adjustments to the ratios to fit their information needs.
B. Limitations
1. Uses historical data to predict the future.
2. Ratio calculations differ depending on accounting rules used and information disclosures available from the firms.
3. Financial managers can manipulate the numbers reported to make ratios appear more favorable. Changes in accounting method or changes in corporate structure make analysis difficult.
4. It is difficult to find a comparable firm of similar size with the same industry classification.
III. The five primary ratios are related as follows:
PRIMARY RATIOS
RETURN ON EQUITY | = | RETURN ON ASSETS | X | LEVERAGE |
Overall Profitability | = | Asset Profitability | X | Amount of Debt/ Financing Performance |
Net IncomeAverage Equity | = | Net IncomeAverage Assets | X | Average AssetsAverage Equity |
| | PROFIT MARGIN | X | ASSET TURNOVER | | |
| | Profitability/ Operating Performance | | Asset/ Investing Performance | | |
| | Net IncomeSales | X | SalesAverage Assets | | |
Why do we use average balance sheet numbers? Because we are comparing balance sheet items measured at a point in time to income statement items measured over a period of time. So we use the average balance sheet number from the beginning and ending of the income...
