INTRODUCTION
Knowing how to calculate and use financial ratios is important for not only analysts, but for investors, lenders and more. Ratios allow analysts to compare a various aspect of a company's financial statements against others in its industry, to determine a company's ability to pay dividends, and more.

The material presented in this section is extremely important to know for your exam. The majority of the questions you see on your exam, within the accounting section, will require you to have excellent knowledge on how to calculate and manipulate ratios. You also need to recognize how ratios are interrelated and how the results of two or more other ratios can be used to calculate other ratios.

A. ANALYZING FINANCIAL STATEMENTS

I. Common-Size Financial Statements
Common-size balance sheets and income statements are used to compare the performance of different companies or a company's progress over time.

  • A Common-Size Balance Sheet is a balance sheet where every dollar amount has been restated to be a percentage of total assets.
    • Calculated as follows:

                         Formula 7.1

% value of balance sheet account = Balance sheet account
                                                                    Total Assets
  • A Common-Size Income Statement is an income statement where every dollar amount has been restated to be a percentage of sales.
    • Calculated as follows:

                         Formula 7.2

% value of income statement account = Income statement account
                                                                   Total Sales (Revenues)

Example: FedEx Common Size Balance Sheet and Income Statement
At first glance, all numbers stated within FedEx's income statement in figure 7.1, and balance sheet in figure 7.2, can seem daunting. It requires close examination to determine whether operating expenses are increasing or decreasing, or which particular expense comprises the highest percentage total operating expenses.

Figure 7.1: FedEx Consolidated Income Statements

However, if we consider the common-size statements in figures 7.2 and 7.4 below, you can tell at first glance how a company is performing in many areas.

The common-size income statement informs us that salaries and other comprise the largest percentage of total operating expenses and their most recent net income comprises 3.39% of total 2004 revenues. Alternately, the common-size balance sheet in figure 7.4 quickly shows that receivables comprise a large percentage of current assets and are decreasing, and more.

Figure 7.2: FedEx Common-sized Income Statements

Figure 7.3: FedEx Consolidated Balance Sheets


Figure 7.4: FedEx Common-sized Consolidated Balance Sheets


II.Financial Ratios
Classification of Financial Ratios
Ratios were developed to standardize a company's results. They allow analysts to quickly look through a company's financial statements and identify trends and anomalies. Ratios can be classified in terms of the information they provide to the reader.

There are four classifications of financial ratios:

  1. Internal liquidity - The ratios used in this classification were developed to analyze and determine a company's financial ability to meet short-term liabilities.
  2. Operating performance - The ratios used in this classification were developed to analyze and determine how well management operates a company. The ratios found in this classification can be divided into 'operating profitability' and 'operating efficiency'. Operating profitability relates the company's overall profitability, and operating efficiency reveals if the company's assets were utilized efficiently.
  3. Risk profile - The ratios found in this classification can be divided into 'business risk' and 'financial risk'. Business risk relates the company's income variance, i.e. the risk of not generating consistent cash flows over time. Financial risk is the risk that relates to the company's financial structure, i.e. use of debt.
  4. Growth potential - The ratios used in this classification are useful to stockholders and creditors as it allows the stockholders to determine what the company is worth, and allows creditors to estimate the company's ability to pay its existing debt and evaluate their additional debt applications, if any.
Internal Liquidity Ratios

Related Articles
  1. Investing

    The Common-Size Analysis of Financial Statements

    Using common-size financial statements helps investors spot trends that a raw financial statement may not uncover.
  2. Investing

    Explaining the Common-Size Balance Sheet

    A common-size balance sheet shows the percentage of each listed item as compared to the total value of related entries, as well as their numerical values.
  3. Investing

    Reading the Balance Sheet

    Learn about the components of the statement of financial position and how they relate to each other.
  4. Investing

    Ratio Analysis Tutorial

    If you don't know how to evaluate a company's present performance and its possible future performance, you need to learn how to analyze ratios.
  5. Investing

    Breaking Down The Balance Sheet

    Knowing what the company's financial statements mean will help you to analyze your investments.
  6. Investing

    Useful Balance Sheet Metrics

    These metrics can help you better understand the information found on balance sheets.
  7. Investing

    Ratio Analysis

    Ratio analysis is the use of quantitative analysis of financial information in a company’s financial statements. The analysis is done by comparing line items in a company’s financial ...
Frequently Asked Questions
  1. Why Does Larry Page Pay Himself a $1 Salary?

    Google co-founder Larry Page continues to take an annual salary of only $1 as chief executive officer.
  2. What is Common Stock and Preferred Stock?

    Learn about the differences between common and preferred shares. Explore situations where preferred shares have more favorable ...
  3. Can CareCredit be Used for Family Members?

    Learn more about the available options that CareCredit offers to pay for out-of-pocket medical procedures with little to ...
  4. What is a Wash Sale?

    The Wash-Sale rule was established to forbid a loss deduction of a security sold.
Trading Center