Financial analysis can make use of ratio analysis, which shows how data relates to other data. Financial statement ratios use two or more lines from a financial statement to perform mathematical calculations. Some common ratios used in financial analysis include liquidity ratios, profitability ratios, leverage ratios, debt ratios, turnover ratios, and solvency ratios.
Liquidity ratios are used to show how liquid a business is, meaning whether they are able to quickly turn its assets into cash. These ratios show whether a company can afford its expenses. Liquidity ratios include the current ratio, cash coverage ratio, quick ratio, and liquidity index. The current ratio is a common ratio used to determine liquidity. To determine this, the business refers to the balance sheet for the current assets and current liabilities. The current ratio is found by dividing the number of current assets by the current liabilities:
Current Ratio = Current Assets / Current Liabilities
If a business has $500,000 in current assets and $400,000 in current liabilities, the current ratio would then equal 1.25, which shows the business can afford its expenses and pay off current liabilities with its assets.
Profitability ratios show whether a business can generate a profit. These include the operating profit ratio, return on equity, gross profit ratio, and break-even point. The operating profit ratio, for example, can be calculated by dividing profits by sales. Leverage ratios show whether a business relies on debt to cover operational costs. These types of ratios include debt to equity ratio, fix-charged coverage, and debt service coverage ratio. For example, the debt-to-equity ratio is calculated by dividing the total debt by the total equity:
Debt-to-Equity = Debt / Equity
If the business had $80,000 in debt and $50,000 in equity, the ratio would equal 1.6.
Efficiency ratios show the business's inputs and outputs. A common type of efficiency ratio is the turnover ratio, which determines the amount of output per input. Turnover ratios are also further categorized into several types, including the inventory turnover ratio and the asset turnover ratio.
Solvency ratios show a company's long-term debt and determine its ability to meet these obligations. Solvency ratios include the time's interest earned ratio, the debt-to-service ratio, and the debt-to-asset ratio. For example, the debt-to-asset ratio, also referred to simply as the debt ratio, is easily determined by dividing the total debt or liabilities by total assets:
Debt-to-Asset Ratio = Total Liabilities / Total Assets
If the business has debt or liabilities equal to $30,000 and assets at $35,000, the debt-to-assets ratio would equal 0.86, which shows the amount of debt owed is very close to the number of assets. Debt ratios help to determine percentage of assets financed with loans.
Examples of Financial Statements
As mentioned, financial analysis used the financial statements of a business for reference to the company's financial standing. These include the balance sheet, the cash flow statements, and the income statement. While each of these statements may follow a slightly different format and may include more detailed information, the basic formats of these statements are as follows:
| Balance Sheet |
|---|
| Assets | Liabilities & Shareholders' Equity |
| Current Assets $30,000 Noncurrent Assets $40,000 | Current Liabilities $60,000 Noncurrent Liabilities $5,000 Shareholders' Equity $5,000 |
| Total Assets $70,000 | Total Liabilities & Shareholders' Equity $70,000 |
The balance sheet is divided into two sections, which are the assets and liabilities, along with shareholders' equity. The basic format shows how assets are further divided into current assets, those due within a year, and noncurrent assets, those not due for at least a year. The right side also shows liabilities further categorized into current and noncurrent liabilities, as well as the shareholder's equity, which is the money owed to the owners and investors.
| Cash Flow Statement |
|---|
| Beginning of Year Cash Balance $300,000 |
| Operating Activities Net Income $700,000 Operating Costs $500,000 Assets $100,000 Accounts Payable $100,000 Liabilities $50,000 Operating Activities Cash $150,000 |
| Investing Activities Income from Securities $600,000 Income from Business Acquisitions $300,000 Acquisition Costs $400,000 Other Investing Costs $150,000 Investing Cash $350,000 |
| Financing Activities Dividends Paid $25,000 Stocks Paid $20,000 Other Financing Income $95,000 Financing Activities Cash $150,000 |
| End of Year Cash Balance $550,000 |
The cash flow statement separates the financial data into three categories: operating activities, investing activities, and financing activities. Operating activities include the cash flow from the costs and income associated with the operations of the business. Investing activities include cash flow from investments and securities, while financing activities consist of the cash flow from dividends and stocks. Free cash flow is the amount of cash left over after deducting operating expenses and all dividends owed to shareholders from the income generated from the business's operations.
| Income Statement |
|---|
| Net Sales $100,000 |
| Cost of Sales $50,000 |
| Gross Profit $50,000 |
| Operating Expenses $15,000 |
| Operating Income $35,000 |
| Taxes $5,000 |
| Net Income $30,000 |
The income statement shows how much income was generated and the expenses that were incurred to run the business. The income statement shows the net sales which first flowed into the business, the gross profit from those sales, and ultimately the net income.
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