Understanding Financial Statements With Ratio Analysis

Understanding Financial Statements With Ratio Analysis

In this lesson, you’re expected to learn about:
– the basics of ratio analysis
– how a company uses liquidity ratios to pay its bills
– using activity ratios to analyze efficiency

Now that we’ve seen the basics of accounting in the last module, we can now look at corporate finance in more detail.

While accountants may try to convince you that a lot of different things go into building financial statements, by themselves these statements are quite useless – unless you know what to look for.

Fortunately, you can overcome this problem by using financial ratios and analysis that turn the financial statements’ data into numbers that can explain how well a company is performing financially.

There are three primary categories of financial statement equations that a company can use to analyze its own performance:

– Liquidity
– Profitability
– Activity Analysis

Liquidity ratios measure a company’s ability to pay its bills. Firms use these equations to measure their ability to pay for the costs of doing business with the assets they currently have.

1) Current Ratio 

You can use the current ratio to look at a company’s liquidity for the next 12 months.

– this ratio calculates the number of times a company can pay off its current liabilities, using its current assets.
– includes stock in addition to other forms of current assets.

Using the Current Ratio 

Here’s what the ratio looks like:
Current Ratio = Current Assets / Current Liabilities

While a low current ratio (i.e. current assets < current liabilities) may indicate that a company is at risk, it can also mean that it’s very good at managing a low stock level. This allows you to keep costs down.
* Both current assets and current liabilities can be found on the balance sheet.
2) Acid Test Ratio (Quick Ratio) 

Some companies that sell very large or expensive items have a difficult time selling stock. To see whether these companies would be able to pay off their debts due within the next year, the acts test ratio (also known as quick ratio) can be used.

– uses all current assets except stock (inventory).
– this value is smaller than the current ratio but it’s still important to consider because it shows whether a company has enough cash and other assets to turn quickly into cash to pay off debts owed and so avoid insolvency.

Using the Acid Test Ratio 

Here’s what the ratio looks like:

Acid Test Ratio = (Current Assets – Stock) / Current Liabilities

low acid test ratio may mean that the company is at risk or is effective at managing its trade debtors.

* All three components of this equation can be found on the balance sheet.
[Optional] Liquidity Ratios
Check out this article to learn more:
Features of Activity Ratios

– also known as efficiency ratios.
– these ratios look at how efficiently a company has managed its short-term assets and liabilities (i.e. its working capital).
– closely linked to liquidity ratios which we just saw.
– each ratio is calculated on a consistent basis.
1) Trade Debtors’ Days

As a company collects the money it’s owed, the total amount the business is owed on average goes up or down depending on how quickly it collects its money.

So companies like to know how many days they take to collect an amount equivalent to the average total amount they’re owed.

They can calculate this amount by using trade debtor days which looks like this:

Gross trade debtors turnover in days
= Average gross trade debtors / (Net credit turnover / 365)

2) Trade Debtors Turnover 

Companies like to know that they’re collecting the money that customers owe them.

To find out exactly how effectively a company is making sales to collect in the future, you can use the ‘trade debtors turnover’ equation, which is calculated as follows:

Trade Debtors Turnover = Turnover / Average trade debtors

3) Trade Creditors Ratio

When a company buys goods or services from a supplier for which it will pay later, it incurs a trade creditor.

You can calculate the average number of days a company takes to pay its creditors with the following equation:

Trade Creditors Ratio = (Trade Creditors / Cost of Sales) x 365

4) Stock Turnover

The number of times a company’s stock is sold and replenished. In this context, turnover means that the total value of a company’s stock has been completely depleted and recovered.

– high turnover: the company uses its stock very quickly.
– low turnover: stock is used up very slowly.

Stock Turnover = Cost of Sales / Average Stock

5) Operating Cycle

The period of time from when a company purchases its stock to the final payment on the sale of that stock is made is called the operating cycle.

– the numbers that go into this equation requires some preliminary calculations.
– this figure tells you how well a company is managing its assets.
– since companies with longer operating cycles tend to have higher liquidity needs, you need to compare this equation with other companies in the industry for it to be useful.

Operating Cycle
= Trade debtors turnover in days + Stock turnover in days

6) Working Capital

If you were to pay off all your short-term debts, what would the value of you remaining assets be? This can be measured with the working capital equation.

– tells you what your net worth is in the short run.
– if a company has more short-term assets than liabilities, its working capital is positive.
– indicates that a company is going to be able to pay off its debts for at least the next year.

Working Capital = Current Assets – Current Liabilities

7) Fixed Asset Turnover

A significant factor of a company’s profitability is how well it manages fixed assets such as properties, production plants, equipment and other assets that contribute to the company’s potential output volume.

The fixed asset turnover equation is given by the following:
Fixed asset turnover = Turnover / Average net fixed assets

[Optional] What Are Activity Ratios?
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