16 Financial Ratios for Analyzing a Company’s Strengths and Weaknesses.pdf

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Read Comments (12)16 Financial Ratios for Analyzing aCompany’s Strengths and WeaknessesbyJoeLan, CFAIn the previous installments of AAII’s Financial Statement Analysis series, I discussed thethree most commonly used financial statements—the income statement, balance sheet andcash flow statement.In this installment of the series, I take an in­depth look at the most commonly used financialratios. Click herefor a downloadable spreadsheet that automatically calculates these ratiosusing financial statement inputs that you provide. Click herefor detailed explanations oncreating the ratios for Stock Investor Prousers.Ratio AnalysisOver the years, investors and analysts have developed numerous analytical tools, conceptsand techniques to compare the relative strengths and weaknesses of companies. Thesetools, concepts and techniques form the basis of fundamental analysis.Ratio analysis is a tool that was developed to perform quantitative analysis on numbersfound on financial statements. Ratios help link the three financial statements together andoffer figures that are comparable between companies and across industries and sectors.Ratio analysis is one of the most widely used fundamental analysis techniques.However, financial ratios vary across different industries and sectors and comparisonsbetween completely different types of companies are often not valid. In addition, it isimportant to analyze trends in company ratios instead of solely emphasizing a single period’sfigures.AAII Journal> September 2012What is a ratio? It’s a mathematical expression relating one number to another, oftenproviding a relative comparison. Financial ratios are no different—they form a basis ofcomparison between figures found on financial statements. As with all types of fundamentalanalysis, it is often most useful to compare the financial ratios of a firm to those of othercompanies.Financial ratios fall into several categories. For the purpose of this analysis, the commonlyused ratios are grouped into four categories: activity, liquidity, solvency and profitability. Also,for the sake of consistency, the data in the financial statements created for the priorinstallments of the Financial Statement Analysis series will be used to illustrate the ratios.Table 1shows the formulas with examples for each of the ratios discussed.
Activity Ratios
Activity ratios are used to measure how efficiently a company utilizes its assets. The ratiosprovide investors with an idea of the overall operational performance of a firm.As you can see from Table 1, the activity ratios are “turnover” ratios that relate an incomestatement line item to a balance sheet line item. As explained in my previous articles, theincome statement measures performance over a specified period, whereas the balancesheet presents data as of one point in time. To make the items comparable for use in activityratios, an average figure is calculated for the balance sheet data using the beginning and

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