7.1 Analysing financial statements using ratios covered in Financial Accounting

Analyzing financial statements using ratios is a common practice to assess a company’s financial performance, liquidity, solvency, and overall health. Financial ratios provide valuable insights into various aspects of a company’s operations and help stakeholders make informed decisions. Here are some key ratios that can be used to analyze financial statements:

1. Liquidity Ratios: Liquidity ratios measure a company’s ability to meet short-term financial obligations. They help assess the company’s ability to cover its short-term liabilities using its short-term assets.
   • Current Ratio = Current Assets / Current Liabilities
   • Quick Ratio (Acid-Test Ratio) = (Current Assets – Inventory) / Current Liabilities
2. Solvency Ratios: Solvency ratios evaluate a company’s long-term financial stability and ability to meet its long-term obligations.
   • Debt-to-Equity Ratio = Total Debt / Total Equity
   • Debt Ratio = Total Debt / Total Assets
   • Interest Coverage Ratio = Operating Income / Interest Expenses
3. Profitability Ratios: Profitability ratios assess the company’s ability to generate profits from its operations.
   • Gross Profit Margin = (Gross Profit / Revenue) * 100
   • Operating Profit Margin = (Operating Profit / Revenue) * 100
   • Net Profit Margin = (Net Profit / Revenue) * 100
   • Return on Assets (ROA) = Net Income / Average Total Assets
   • Return on Equity (ROE) = Net Income / Average Total Equity
4. Efficiency Ratios: Efficiency ratios measure how effectively a company utilizes its assets and resources to generate revenue.
   • Asset Turnover = Revenue / Average Total Assets
   • Inventory Turnover = Cost of Goods Sold / Average Inventory
   • Receivables Turnover = Revenue / Average Accounts Receivable
5. Market Ratios: Market ratios relate the company’s stock price to its financial performance and are useful for assessing investor sentiment.
   • Price-to-Earnings Ratio (P/E) = Market Price per Share / Earnings per Share
   • Price-to-Book Ratio (P/B) = Market Price per Share / Book Value per Share
   • Dividend Yield = Dividends per Share / Market Price per Share
6. Coverage Ratios: Coverage ratios assess the company’s ability to cover its various obligations, such as interest payments or dividends.
   • Times Interest Earned (TIE) Ratio = Earnings Before Interest and Taxes (EBIT) / Interest Expenses
   • Dividend Coverage Ratio = Earnings Available for Dividends / Total Dividends