Financial Ratio Analysis

This type of analytical procedure is beneficial to the practitioner as it compares the proportional relationship between two individual amounts in the financial statements. They provide further information to be considered for obtaining the reasonable assurance referenced in the Handbook. These ratios may be comparing balances within one or more financial statements and possibly for more than one fiscal period. There are four main categories of ratios as follows:

1. Profitability Ratios

   This ratio assesses the return on investment. There are many profitability ratios but they all have common elements. The numerator is an income statement balance and thus reflects a return over time. The denominator uses an average balance sheet amount to allow for consistency with the numerator. One common profitability ratio used is the operating margin ratio. It is calculated by:

   (Net income + interest + income tax) divided by Total revenue

   This ratio will indicate the profit margin earned on each dollar of sales.

2. Efficiency Ratios

   This type of ratio analyzes operational efficiency. The two most commonly used ratios in this category are accounts receivable turnover and inventory turnover. Inventory turnover consists of:

   Cost of goods sold divided by Average inventory

   A low ratio may mean that overstocking of inventory is occurring.

3. Solvency Ratios

   The purpose of solvency ratios is determination of a company’s ability to make both the interest and principal payments on its long-term obligations. An example of this kind of ratio is the debt-to-equity ratio. It is calculated by:

   Total long-term debt divided by Total owners’ equity

   This ratio will reveal the source of financing long term investments, on a proportional basis, either through debt or owner’s equity.

4. Liquidity Ratios

   Liquidity ratios test a company’s ability to meet short-term financial obligations. The most commonly used ratio of this type is the current ratio. It is comprised of:

   Current assets divided by Current liabilities

   This ratio will illustrate a company’s ability to pay its liabilities with its current assets.