Intro to Finance: Financial Statement Analysis - Ratio Analysis, Liquidity Solvency Profitability Efficiency Market Ratios

What This Is

Ratio analysis is a financial tool used to evaluate a company's performance and position by comparing its financial metrics to industry averages or its own historical data. It helps investors, creditors, and management make informed decisions by highlighting strengths and weaknesses. For example, if Apple's current ratio is 2.5, it means the company has $2.5 in current assets for every $1 in current liabilities, indicating a strong liquidity position.

Key Formulas & Symbols

• Current Ratio = Current Assets / Current Liabilities where Current Assets = cash, accounts receivable, inventory, and prepaid expenses, Current Liabilities = accounts payable, short-term debt, and accrued expenses.
• Quick Ratio = (Current Assets - Inventory) / Current Liabilities where Inventory is excluded to focus on more liquid assets.
• Debt-to-Equity Ratio = Total Debt / Total Shareholders' Equity where Total Debt = long-term debt and short-term debt, Total Shareholders' Equity = common stock + retained earnings.
• Return on Equity (ROE) = Net Income / Total Shareholders' Equity where Net Income = earnings after taxes.
• Return on Assets (ROA) = Net Income / Total Assets where Total Assets = all assets, including current and non-current.
• Price-to-Earnings (P/E) Ratio = Market Price per Share / Earnings per Share (EPS) where Market Price per Share = current stock price, EPS = net income divided by total shares outstanding.
• Dividend Yield = Annual Dividend per Share / Market Price per Share where Annual Dividend per Share = total dividends paid divided by total shares outstanding.
• Interest Coverage Ratio = Earnings Before Interest and Taxes (EBIT) / Interest Expenses where EBIT = earnings before interest and taxes, Interest Expenses = interest paid on debt.
• Asset Turnover Ratio = Sales / Total Assets where Sales = revenue from sales of goods or services.

Step-by-Step Calculation

1. Calculate the current ratio by dividing current assets by current liabilities. For example, if Apple has $100 billion in current assets and $40 billion in current liabilities, the current ratio is 2.5.
2. Calculate the quick ratio by subtracting inventory from current assets and dividing by current liabilities. For example, if Apple has $80 billion in current assets excluding inventory, and $40 billion in current liabilities, the quick ratio is 2.
3. Calculate the debt-to-equity ratio by dividing total debt by total shareholders' equity. For example, if Apple has $100 billion in total debt and $200 billion in total shareholders' equity, the debt-to-equity ratio is 0.5.
4. Calculate ROE by dividing net income by total shareholders' equity. For example, if Apple has $20 billion in net income and $200 billion in total shareholders' equity, ROE is 10%.
5. Calculate ROA by dividing net income by total assets. For example, if Apple has $20 billion in net income and $500 billion in total assets, ROA is 4%.
6. Calculate P/E ratio by dividing market price per share by EPS. For example, if Apple's market price per share is $150 and EPS is $10, the P/E ratio is 15.
7. Calculate dividend yield by dividing annual dividend per share by market price per share. For example, if Apple pays an annual dividend of $5 per share and the market price per share is $150, the dividend yield is 3.33%.
8. Calculate interest coverage ratio by dividing EBIT by interest expenses. For example, if Apple has $50 billion in EBIT and $5 billion in interest expenses, the interest coverage ratio is 10.
9. Calculate asset turnover ratio by dividing sales by total assets. For example, if Apple has $200 billion in sales and $500 billion in total assets, the asset turnover ratio is 0.4.

Common Mistakes

• Mistake: Using book value instead of market value for WACC.
• Correction: Use market value for WACC to reflect the current market price of the company's debt and equity.
• Mistake: Confusing IRR and NPV ranking.
• Correction: IRR is the rate of return that makes NPV equal to zero, while NPV is the present value of future cash flows at a given discount rate.
• Mistake: Failing to consider the time value of money when calculating present value.
• Correction: Use the present value formula to calculate the present value of future cash flows, taking into account the time value of money.

Exam / CFA Tips

• Tip: Be careful with the order of operations when calculating ratios, as small mistakes can lead to large errors.
• Tip: Make sure to use the correct formula for each ratio, as the formulas can be complex and easy to confuse.
• Tip: Practice, practice, practice! Ratio analysis is a critical skill for finance professionals, and practice problems can help you develop your skills.

Quick Practice Problem

Apple has $100 billion in current assets and $40 billion in current liabilities. What is the current ratio?

Answer: 2.5

Explanation: Current ratio = Current Assets / Current Liabilities = $100 billion / $40 billion = 2.5

Last-Minute Cram Sheet

• The current ratio is a liquidity metric that measures a company's ability to pay its short-term debts.
• The quick ratio is a more conservative liquidity metric that excludes inventory.
• The debt-to-equity ratio measures a company's leverage and risk.
• ROE is a profitability metric that measures a company's return on equity.
• ROA is a profitability metric that measures a company's return on assets.
• P/E ratio is a valuation metric that measures a company's stock price relative to its earnings.
• Dividend yield is a valuation metric that measures a company's dividend payment relative to its stock price.
• Interest coverage ratio measures a company's ability to pay its interest expenses.
• Asset turnover ratio measures a company's efficiency in generating sales from its assets.
• The WACC formula requires market values for debt and equity, not book values.