Method used by interested parties such as investors, creditors, and management to evaluate the past, current, and projected conditions and performance of the firm. Ratio analysis is the most common form of financial analysis.

1. Financial Statement Analysis

2. Ratio & Risk Analysis
 Comparison of financial ratios against:
o Other company ratios.
o Stock market averages.
o Industry guidelines.
o Lender policies.
o Alternative investment opportunities.
o Widely accepted standards.
o Investor’s personal experience.
 Use and limitations of financial ratios:
o A reference point is needed. To be meaningful, most ratios must be compared to historical values, of the same firm, the firm’s
forecasts, or ratios of similar firms.
o Most ratios by themselves are not highly meaningful. They should be viewed as indicators, with several of them combined to paint
a picture of the firm’s situation.
o Year-end values may not be representative. Certain account balances are used to calculate ratios may increase or decrease at the
end of the accounting period because of seasonal factors. Such changes may distort the value of the ratio. Average values should
be used when they are available.
o Ratios are subject to the limitations of accounting methods. Different accounting choices may result in significantly different ratio
values.
ABC Company
BALANCE SHEET
December 31
Year 2 Year 1
Current Assets:
Cash and cash equivalents $50,000 $35,000
Trading securities (at fair value) 75,000 65,000
Accounts receivable 300,000 290,000
Inventory (at lower of cost or market) 290,000 275,000
Total current assets 715,000 665,000
Investments available-for-sale (at fair value) 350,000 300,000
Fixed Assets:
Property, plant, and equipment (at cost) 1,900,000 1,800,000
Less: Accumulated depreciation (385,000) (350,000)
1,515,000 1,450,000
Goodwill 35,000 35,000
Total Assets $2,615,000 $2,450,000
Current liabilities:
Accounts payable $150,000 $125,000
Notes payable 325,000 375,000
Accrued and other liabilities 220,000 200,000
Total current liabilities 695,000 700,000
Long-term Debt:
Bonds and notes payable 650,000 600,000
Total liabilities 1,345,000 1,300,000
Stockholders' Equity:
Common stock (100,000 shares
outstanding) 500,000 500,000
Additional paid-in capital 350,000 350,000
Retained earnings 420,000 300,000
Total equity 1,270,000 1,150,000
Total liabilities and equity $2,615,000 $2,450,000

3. ADDITIONAL INFORMATION
December 31
Year 2
Sales $1,800,000
Cost of goods sold (1,000,000)
Gross profit 800,000
Operating expenses (486,970)
Interest expense (10,000)
Net income before income taxes 303,030
Income taxes (34%) (103,030)
Net income after income taxes $200,000
Net income after income taxes $200,000
Outstanding shares 100,000
Earnings per share $2
Operating cash flows $255,000
Dividends for the year (per share) $0.80
Market price per share $12.00
Liquidity Ratios
Defined
Liquidity ratios demonstrate a company’s ability to meet its current obligations.
Year 2 Year 1
Working Capital
Current assets - Current liabilities
Current assets $715,000 $665,000
Current liabilities 695,000 700,000
Working Capital $20,000 ($35,000)
Year 2 Year 1
Current Ratio or Working Capital Ratio
Current assets / Current liabilities
Current assets $715,000 $665,000
Current liabilities 695,000 700,000
Current Ratio or Working Capital Ratio 1.03 0.95
Analysis
Assuming the industry average is 1.5. The ratio and therefore ABC company’s ability to meet its short-term obligations, has improved,
though it is low compared to the industry average. One widely accepted standard holds that a current ratio of 2-to-1 indicates that a
company has sufficient liquid assets to meet its current liabilities.

4. Acid-Test or Quick Ratio Year 2 Year 1
(Cash equivalents + Marketable securities + Net receivables) / Current liabilities
Cash equivalents $50,000 $35,000
Marketable securities 75,000 65,000
Net receivables 300,000 290,000
425,000 390,000
Current liabilities 695,000 700,000
Acid-Test or Quick Ratio 0.61 0.56
Analysis
Assuming the industry average is 0.80 The industry average of 0.80 is higher than ABC ratio, which indicates that ABC Company may have
trouble meeting short-term needs. A quick ratio of 1:1 is normally regarded as satisfactory.
Year 2 Year 1
Cash Ratio
(Cash equivalents + Marketable securities) / Current liabilities
Cash equivalents $50,000 $35,000
Marketable securities 75,000 65,000
125,000 100,000
Current liabilities 695,000 700,000
Cash Ratio 0.18 0.14
Activity Ratios
Accounts Receivable Turnover
Net credit sales / Average receivables
Net credit Sales $1,800,000
Beginning receivables 290,000
Ending receivables 300,000
Average receivables 295,000
Accounts Receivable Turnover Times 6.10
Analysis
This ratio indicates the receivables’ quality and indicates the success of the firm in collecting outstanding receivables. Faster turnover
gives credibility to the current and acid-test ratios.
Accounts Receivable Turnover in Days
Average receivables / (Net credit sales / 365)
Beginning receivables $290,000
Ending receivables 300,000
Average receivables $295,000
Net credit Sales 1,800,000
365 Days 365
4,932
Accounts Receivable Turnover in Days days 59.82
Analysis
This ratio indicates the average number of days required to collect accounts receivable.
Inventory Turnover
Cost of goods sold / Average inventory
Cost of goods sold $1,000,000
Beginning inventory $275,000
Ending inventory 290,000
Average inventory 282,500
Inventory Turnover Times 3.54
Analysis
This measure of how quickly inventory is sold is an indicator of enterprise performance. The higher the turnover, in general, the better
the performance. Calculates the number of times inventory is turned in a year.

5. Inventory Turnover in Days
Average inventory / (Cost of goods sold / 365)
Beginning inventory $275,000
Ending inventory 290,000
Average inventory $282,500
Cost of goods sold 1,000,000
365 Days 365
2,740
Inventory Turnover in Days Days 103.11
Analysis
This ratio indicates the average number of days required to sell inventory.
Operating Cycle
A/R turnover in days + inventory tunover in days
Accounts Receivable Turnover in Days 59.82
Inventory Turnover in Days 103.11
Operating Cycle Days 162.93
Analysis
The operating cycle indicates the number of days between acquisition of inventory and realization of cash from selling the inventory.
Working Capital Turnover
Sales / Average working capital
Sales $1,800,000
Beginning working capital (35,000)
Ending working capital 20,000
Average working capital (7,500)
Working Capital Turnover Times 240
Analysis
This ratio indicates how effectively working capital is used.
Total Asset Turnover
Net Sales / Average total assets
Net sales $1,800,000
Beginning total assets $2,450,000
Ending total assets 2,615,000
Average total assets 2,532,500
Total Asset Turnover Times 0.71
Analysis
This ratio is an indicator of how ABC Company makes effective use of its assets. A high ratio indicates effective asset use to generate
sales.
Accounts Payable Turnover
Cost of goods sold / Average accounts payable
Cost of goods sold 1,000,000
Beginning accounts payable 125,000
Ending accounts payable 150,000
Average accounts payable 137,500
Accounts Payable Turnover Times 7
Analysis
This ratio indicates the number of times trade payables turn over during the year. A low turnover may indicate a delay in payment, such
as from a shortage of cash.

6. Days in Accounts Payable
Average accounts payable / (Cost of goods sold / 365)
Beginning accounts payable $125,000
Ending accounts payable 150,000
Average accounts payable $137,500
Cost of goods sold 1,000,000
365 Days 365
2,740
Days in Accounts Payable Days 50.19
Analysis
This ratio indicates the average length of time trade payables are outstanding before they are paid.
Profitability Ratios
Defined
Profitability ratios indicate a company’s ability to earn a satisfactory return on sales, total assets, and invested capital.
Net Profit Margin
Net income / Net sales
Net income $200,000
Net sales 1,800,000
Net Profit Margin 11.11%
Analysis
This ratio indicates profit rate, when used with the asset turnover ratio, indicates rate of return on assets.
Return on Total Assets
Net income / Average total assets
Net income $200,000
Beginning total assets $2,450,000
Ending total assets 2,615,000
Average total assets 2,532,500
Return on Total Assets 7.9%
Return on Investment
(Net income + Interest expense (1 - Tax rate)) / Average Long-term liabilities + Equity
Net Income $200,000
Interest expense (1 - Tax rate) 6,600
$206,600
Beginning Long-term liabilities $600,000
Ending Long-term liabilities 650,000
Beginning Equity 1,150,000
Ending Equity 1,270,000
Average long-term liabilities + Equity 1,835,000
Return on Investment 11.3%
Analysis
ROI measures the performance of the firm without regard to the method of financing.
Return on Common Equity
(Net income - Preferred dividends) / Average common equity
Net income $200,000
less Preferred dividends 0
$200,000
Beginning Equity 1,150,000
Ending Equity 1,270,000
Average common equity 1,210,000
Return on Common Equity 16.5%

7. Net Operating Margin Percentage
Net operating income / Net sales
Gross Profit $800,000
Operting expenses 486,970
Net operating income $313,030
Net sales 1,800,000
Net Operating Margin Percentage 17.39%
Gross (Profit) Margin Percentage
Gross (profit) margin / Net sales
Net Sales $1,800,000
Cost of Goods Sold 1,000,000
Gross (profit) margin $800,000
Net Sales 1,800,000
Gross (Profit) Margin Percentage 44.44%
Operating Cash Flow Per Share
Operating cash flow / Common shares outstanding
EBIT $313,030
Depreciation 45,000
Taxes (103,030)
Operating cash flows $255,000
Common shares outstanding 100,000
Operating Cash Flow Per Share per share $2.55
Investor Ratios
Degree of Financial Leverage
Earnings before interest and taxes / Earnings before taxes
Earnings before interest and taxes $313,030
Earnings before taxes 303,030
Degree of Financial Leverage 1.033
Analysis
The degree of financial leverage is the key factor by which net income will change with a change in earnings before interest and taxes.
The degree of financial leverage indicates the leverage factor for recurring earnings.
Earnings Per Share
(Net income - Preferred dividends) / Weighted average number of common shares outstanding
Net income $200,000
Preferred dividends 0
$200,000
Beginning common shares 100,000
Ending common shares 100,000
Average common shares 100,000
Earnings Per Share per share $2
Price / Earnings Ratio
Market price per share / Diluted earnings per share
Market price per share $12
Diluted earnings per share $2
Price / Earnings Ratio $6
Analysis
This statistic indicates the investment potential of an enterprise; a rise in this ratio indicates that investors are pleased with the firm’s
opportunity for growth.

8. Dividend Payout Ratio
Dividends per common share / Diluted earnings per share
Dividends per common share $0.80
Diluted earnings per share $2
Dividend Payout Ratio 40%
Analysis
This ratio indicates the portion of current earnings being paid out in dividends.
Dividend Yield
Dividends per common share / Market price per common share
Dividends per common share $0.80
Market price per share $12
Dividend Yield 6.67%
Analysis
This ratio indicates the relationship between dividends and market price.
Year 2 Year 1
(Total stockholders' equity - Preferred stock) / Number of common shares outstanding
Total stockholders' equity $1,270,000 $1,150,000
Preferred stock 0 0
$1,270,000 $1,150,000
Number of common shares outstanding 100,000 100,000
Book Value Per Share $12.70 $11.50
Analysis
This ratio indicates the amount of stockholders’ equity that relates to each share of common stock. Note that preferred stock should be
stated at liquidity value if other than book value.
Long-Term Debt-Paying Ability Ratios
Year 2 Year 1
Debt to Equity
Total liabilities / Common stockholders' equity
Total liabilities $1,345,000 $1,300,000
Common stockholders' equity $1,270,000 $1,150,000
Debt to Equity 1.06 1.13
Analysis
This ratio indicates the degree of protection to creditors in case of insolvency. The lower this ratio, the better the company’s position. In
ABC Company’s case, the ratio is very high, indicating that a majority of funds come from creditors. However, the ratio is improving.
Year 2 Year 1
Debt Ratio
Total liabilities / Total assets
Total liabilities $1,345,000 $1,300,000
Total assets $2,615,000 $2,450,000
Debt Ratio 51.4% 53.1%
Analysis
This debt ratio indicates that more than half of the assets are financed by creditors.

9. Times Interest Earned
Recurring income before taxes and interest / Interest
Net income before income taxes $303,030
Interest expense 10,000
Recurring income before taxes and interest $313,030
Interest expense 10,000
Times Interest Earned times 31.30
Analysis
This ratio reflects the ability of a company to cover interest charges. It uses income before interest and taxes to reflect the amount of
income available to cover interest expense.
Operating Cash Flow to Total Debt
Operating Cash Flow / Total Debt
Operating cash flow $255,000
Total debt 1,345,000
Operating Cash Flow to Total Debt 18.96%
Analysis
This ratio indicates the ability of the company to cover total debt with yearly cash flow.
Z Score
Defined
A model designed by Edward Altman that indicates an unhealthy company that is headed for failure.
Healthy score > 2.99
Unhealthy score < 1.81
Formula
Z Score = 1.2(X1) + 1.4(X2) + 3.3(X3) + 6.0(X4) + 1.0 (X5)
X1 = working capital / total assets
X2 = retained earnings / total assets
X3 = income before interest and taxes / total assets
X4 = market value of equity / total liabilities
X5 = sales / total assets
Sample Company Information
International R.R.
Paper Macy's 3M Donnelley
Gross Profit Margin 30.1% 45.7% 53.2% 24.2%
EBIT Margin 3.2% 5.8% 23.2% 5.5%
EBITDA Margin 15.9% 11.7% 27.6% 13.3%
Pre-Tax Profit Margin 0.5% 3.4% 22.4% 2.0%
Interest Coverage 1.2 2.4 27.9 1.6
Current Ratio 1.9 1.3 2.4 1.9
Quick Ratio 1.2 0.2 1.6 1.4
Leverage Ratio 4.4 4.4 2.0 4.1
Receivables Turnover 7.5 55.6 7.1 5.7
Inventory Turnover 7.5 2.6 4.3 14.1
Asset Turnover 0.9 1.1 0.9 1.1
Revenue to Assets 1.0 1.2 0.9 1.1
Return on Invested Capital 1.5% 3.8% 20.8% 1.4%
Return on Assets 80.0% 2.2% 13.8% 90.0%
Debt/Common Equity Ratio 1.51 1.58 0.35 1.61
Total Debt/ Equity 1.57 1.73 0.45 1.61