In financial ratio analysis, we select the relevant information—primarily the financial statement data—and evaluate it. We show how to incorporate market data and economic data in the analysis of financial ratios. Finally, we show how to interpret financial ratio analysis, identifying the pitfalls that occur when it’s not done properly.

Return-on-Investment Ratios

Recap: Return-on-Investment Ratios

Du Pont System

Operating Cycle

Ratios and Their Classification

A financial ratio is a comparison between one bit of financial information and another. Consider the ratio of current assets to current liabilities, which we refer to as the current ratio. This ratio is a comparison between assets that can be readily turned into cash—current assets—and the obligations that are due in the near future—current liabilities. A current ratio of 2, or 2:1, means that we have twice as much in current assets as we need to satisfy obligations due in the near future.
Ratios can be classified according to the way they are constructed and the financial characteristic they are describing. For example, we will see that the current ratio is constructed as a coverage ratio (the ratio of current assets—available funds—to current liabilities—the obligation) that we use to describe a firm’s liquidity (its ability to meet its immediate needs).
There are as many different financial ratios as there are possible combinations of items appearing on the income statement, balance sheet, and statement of cash fl ows. We can classify ratios according to the financial characteristic that they capture.
When we assess a firm’s operating performance, a concern is whether the company is applying its assets in an efficient and profitable manner. When an investor assesses a firm’s financial condition, a concern is whether the company is able to meet its financial obligations. The investor can use financial ratios to evaluate five aspects of operating performance and financial condition:

• Return on investment


• Liquidity


• Profitability


• Activity


• Financial leverage

There are several ratios refl ecting each of the five aspects of a firm’s operating performance and financial condition. We apply these ratios to the Fictitious Corporation, whose balance sheets, income statements, and statement of cash fl ows for two years are shown in Tables 3.1, 3.2, and 3.3, respectively. We refer to the most recent fiscal year for which financial statements are available as the “current year.” The “prior year” is the fiscal year prior to the current year.
The ratios we introduce here are by no means the only ones that can be formed using financial data, though they are some of the more commonly used. After becoming comfortable with the tools of financial analysis, an investor will be able to create ratios that serve a particular evaluation objective.
TABLE 3.1 Fictitious Corporation Balance Sheets for Years Ending December 31 (in thousands)

TABLE 3.2 Fictitious Corporation Income Statements for Years Ending December 31 (in thousands)