Financial statements are the language of business. They tell us how a company earns revenue, manages costs, and uses assets to generate profit.
However, numbers alone don’t reveal much until they are analyzed.
This is where financial statement analysis comes in — allowing us to evaluate performance, liquidity, leverage, and profitability.
This chapter focuses on how to work with financial statements, interpret ratios, and compare firms across time and industries.
Cash Flow and Financial Statements: A Closer Look
Understanding cash movement is fundamental. A company can be profitable yet face a cash shortage, or it can generate positive cash flow even when profits appear low on paper.
Sources of Cash
Activities that generate cash for a firm include:
- A decrease in assets (e.g., selling equipment or inventory)
- An increase in liabilities (e.g., borrowing funds or issuing bonds)
Uses of Cash
Activities that consume cash include:
- An increase in assets (e.g., purchasing machinery or inventory)
- A decrease in liabilities (e.g., repaying loans)
These inflows and outflows are tracked through the Statement of Cash Flows, which groups transactions into three categories:
- Operating Activities – Day-to-day business operations like sales and expenses.
- Investing Activities – Buying or selling long-term assets.
- Financing Activities – Raising or repaying capital through debt and equity.
Standardized Financial Statements
It’s hard to compare two companies of different sizes directly.
To make meaningful comparisons, we use standardized financial statements, which present items as percentages.
Common-Size Statements
- On the Balance Sheet, items are shown as a percentage of total assets.
- On the Income Statement, items are expressed as a percentage of sales.
- On the Cash Flow Statement, items can be shown as a percentage of total cash inflows.
These help in understanding structure and composition, regardless of absolute size differences.
Common-Base Year Statements
Also called trend analysis, these show financial statement items relative to a specific base year.
This approach highlights growth trends and changes in performance over time.
Ratio Analysis
Financial ratios summarize relationships between key elements of financial statements.
They help assess liquidity, profitability, leverage, and efficiency — and are useful for comparisons across firms, periods, and industries.
There are five main categories of financial ratios:
- Liquidity ratios
- Solvency (leverage) ratios
- Asset management (turnover) ratios
- Profitability ratios
- Market value ratios
Liquidity Ratios (Short-Term Solvency)
Liquidity ratios measure a company’s ability to meet short-term obligations.
1. Current Ratio
Formula:
Current Ratio = Current Assets ÷ Current Liabilities
It tells how many dollars in current assets are available for each dollar of current liabilities.
A higher ratio indicates better liquidity, but too high might mean idle assets.
2. Quick (Acid-Test) Ratio
Formula:
Quick Ratio = (Current Assets – Inventory) ÷ Current Liabilities
Inventory is excluded since it’s the least liquid current asset.
A low quick ratio may indicate difficulty in paying short-term debts without selling inventory.
3. Cash Ratio
Formula:
Cash Ratio = Cash ÷ Current Liabilities
It focuses on the most liquid asset — cash. This is important for firms facing immediate obligations.
4. Net Working Capital to Total Assets
Formula:
NWC to Total Assets = Net Working Capital ÷ Total Assets
This shows how much of the company’s total assets are funded by short-term capital.
5. Interval Measure
Formula:
Interval Measure = Current Assets ÷ Average Daily Operating Costs
It measures how long a firm can continue operations with existing liquid assets before needing new financing.
Long-Term Solvency Ratios (Financial Leverage)
These ratios evaluate a firm’s ability to meet long-term obligations and use debt effectively.
1. Total Debt Ratio
Formula:
Total Debt Ratio = (Total Assets – Total Equity) ÷ Total Assets
It shows what proportion of assets is financed through debt.
Example: A ratio of 0.4 means 40% of assets are funded by debt.
2. Debt-to-Equity Ratio
Formula:
Debt-Equity Ratio = Total Debt ÷ Total Equity
It compares borrowed funds with owners’ capital — indicating leverage.
3. Equity Multiplier
Formula:
Equity Multiplier = Total Assets ÷ Total Equity
A high equity multiplier suggests significant use of debt financing.
4. Long-Term Debt Ratio
Formula:
Long-Term Debt Ratio = Long-Term Debt ÷ (Long-Term Debt + Total Equity)
It focuses only on long-term obligations, excluding short-term liabilities.
5. Times Interest Earned (TIE) Ratio
Formula:
TIE Ratio = EBIT ÷ Interest
Measures how comfortably a firm can cover its interest payments.
A value above 1.5–2.0 is generally acceptable.
6. Cash Coverage Ratio
Formula:
Cash Coverage Ratio = (EBIT + Depreciation) ÷ Interest
It’s a broader measure, accounting for non-cash expenses like depreciation.
This ratio helps assess the true cash ability to pay interest.
Asset Management Ratios (Turnover Ratios)
These ratios evaluate how efficiently a firm uses assets to generate sales.
1. Inventory Turnover
Formula:
Inventory Turnover = Cost of Goods Sold ÷ Inventory
It shows how many times inventory is sold and replaced during the year.
A higher turnover indicates efficient inventory management.
2. Days’ Sales in Inventory
Formula:
Days’ Sales in Inventory = 365 ÷ Inventory Turnover
Shows the average number of days inventory sits before being sold.
A shorter period means faster sales.
3. Receivables Turnover
Formula:
Receivables Turnover = Sales ÷ Accounts Receivable
Measures how quickly a firm collects payments from customers.
4. Days’ Sales in Receivables
Formula:
Days’ Sales in Receivables = 365 ÷ Receivables Turnover
Shows how many days, on average, it takes to collect outstanding receivables.
5. Net Working Capital (NWC) Turnover
Formula:
NWC Turnover = Sales ÷ Net Working Capital
Measures how efficiently the firm uses its working capital to support sales.
6. Fixed Asset Turnover
Formula:
Fixed Asset Turnover = Sales ÷ Net Fixed Assets
Shows how effectively the company uses fixed assets (machinery, property) to generate revenue.
7. Total Asset Turnover
Formula:
Total Asset Turnover = Sales ÷ Total Assets
Indicates how efficiently the company utilizes all assets to produce sales.
Profitability Ratios
Profitability ratios measure the company’s ability to generate profit from sales and investments.
1. Profit Margin
Formula:
Profit Margin = Net Income ÷ Sales
Shows how much profit is generated per dollar of sales.
A high margin reflects good cost control and pricing strategy.
2. Return on Assets (ROA)
Formula:
ROA = Net Income ÷ Total Assets
Measures how efficiently a firm uses its assets to earn profit.
3. Return on Equity (ROE)
Formula:
ROE = Net Income ÷ Total Equity
Indicates how much profit shareholders earn for every dollar invested.
A higher ROE reflects efficient use of shareholders’ capital.
Market Value Ratios
Market value ratios link accounting data with stock market performance.
1. Price-Earnings (P/E) Ratio
Formula:
P/E Ratio = Price per Share ÷ Earnings per Share
Shows how much investors are willing to pay per dollar of earnings.
A high P/E suggests investor confidence and expected growth.
2. Market-to-Book Ratio
Formula:
Market-to-Book Ratio = Market Value per Share ÷ Book Value per Share
Compares the market’s valuation of a firm to its historical accounting value.
If greater than 1, the firm is valued above its recorded cost base.
Summary
- Cash flow analysis tracks inflows and outflows to understand financial health.
- Standardized statements enable comparison across firms and years.
- Liquidity ratios assess short-term solvency.
- Leverage ratios measure debt use and financial stability.
- Turnover ratios show asset utilization efficiency.
- Profitability ratios evaluate earnings performance.
- Market ratios link company results to investor perception.
Together, these tools provide a 360° view of financial performance.
FAQs About Working with Financial Statements
1. What is the main purpose of financial ratio analysis?
To evaluate a firm’s performance, efficiency, and financial position.
2. What is a good current ratio?
Typically above 1.5, indicating sufficient assets to cover short-term liabilities.
3. How do liquidity and solvency differ?
Liquidity focuses on short-term obligations, while solvency evaluates long-term debt sustainability.
4. Why are common-size statements useful?
They standardize figures as percentages, allowing easier comparison across firms of different sizes.
5. What is the difference between ROA and ROE?
ROA measures return on total assets; ROE measures return specifically to shareholders.
6. What does a high inventory turnover mean?
Efficient inventory management and faster sales cycles.
7. What does a high P/E ratio indicate?
Investors expect strong future growth and profitability.
8. What does market-to-book ratio signify?
If greater than 1, the market values the company higher than its accounting worth.
