Chapter 4 Financial Statement Analysis Tools Introduction You’ve studied ratio analysis several times in your financial studies. This chapter demonstrates how to set up ratios in Excel. The process is straight-forward. It involves typing the ratio formulas into Excel and pulling the data for the calculations for the related financial statements. Review of Ratios This week's discussion focuses on financial indicators or ratios that we use to gain further insight into company performance. Financial ratios are calculated by comparing two account balances on the financial statements of a company. The result is a performance measure that when compared to industry standards helps investors better gauge a company's performance in specific areas. The general categories of comparison include liquidity, operating (also called activity or utilization), and profitability, solvency, and market ratios. Our discussion begins with common size financial statements. When I look at Company X's balance sheet, I might want to know how their fixed assets compare as a percent of total assets to Company Y. To facilitate this comparison, elements of the balance sheet are presented as a percentage of total assets. In a common size balance sheet, elements of the statement are presented as a percentage of total assets. In a common size income statement, elements of the statement are presented as percentages of net sales or revenues. This presentation device allows for comparison of the relative amount of assets, liabilities, equities and income categories across time and among different sized firms, without calculation by the reader. For example, Ford may report cash of $4.836 billion and SkyTel cash of $20 million. Cash represented 2 % and 2.7 % of these companies' assets, respectively. Thus, although SkyTel has much less absolute cash than Ford, its relative cash position is actually higher than Ford's. Common size financial statements enables users of financial statements to evaluate the relative efficiency and the relative claims on economic resources of firms regardless of the amount of the absolute value of the entity's economic resources or the changes therein. Now let's look at measures of performance through ratio analysis of individual financial statement accounts. Different finance books divide ratios into different categories, but the following are most common: Liquidity Ratios Liquidity ratios help lenders and other creditors evaluate an entity's ability to pay its bills as they become due. The most commonly used liquidity ratio is the current ratio. The current ratio is simply the ratio of current assets to current liabilities (hence the name "current" ratio). Analysts usually evaluate the sufficiency of the current ratio by comparing it across time and to the industry average.

Because the current ratio includes inventory (which often cannot be quickly converted to cash), many analysts prefer to use the quick or acid test ratio to evaluate liquidity. This ratio is simply the ratio of current assets other than inventory to current liabilities. Another way to evaluate solvency is simply to compare current holdings in cash and near cash (marketable securities) and the company's ability to generate cash as measured by cash flows from operating activities to current liabilities. The ratio of cash + marketable securities + cash flows from operating activities to current liabilities is called the cash flow liquidity ratio. Activity Ratios Activity ratios help lenders and other creditors and equity investors evaluate an entity's ability to manage its assets. The first key activity ratio is the average collection period. This is the ratio of accounts receivable to daily sales. By comparing this ratio across time and to industry averages, analysts can gauge if the company is efficient at collecting its money and if it has changed its credit policies -- particularly if it has loosened its credit policies as evidenced by a longer collection