CHAPTER 5 FINANCIAL RATIO ANALYSIS Financial Ratio a relative magnitude of two selected numerical values taken from an enterprise's

s financial statements. a comparison in fraction, proportion, decimal or percentage form of two significant figures taken from financial statements. expresses the direct relationship between two or more quantities in the balance sheet and increase statement of a business firm Purpose Through ratio analysis, the financial statements user comes into possession of measures which provide insight into the profitability of operations, the soundness of the firms short-term and long-term financial condition and the efficiency with which management has utilized the resources entrusted to it. Limitations of Financial Ratios 1. Ratios must used only as financial tools, that is, as indicators of weakness or strength and not to be regarded as good or bad per se. 2. Financial ratios are generally computed directly from the companys financial statements, without adjustment. Conventional financial statements prepared in accordance with GAAP have a number of weaknesses that managers must consider if the ratios are to be meaningful. 3. Ratios are a composite of many different figures- some covering a time period, others an instant time and still others representing averages. 4. Ratios to be meaningful should be evaluated with the use of certain yardsticks. The most common of these are: a. Companys own experience (prior years) b. Other companies in the same industry (industry averages) c. A standard set by management (a budget) d. Rules of thumb Kinds of Financial Ratios 1. Liquidity ratios ratios that measure the firms ability to meet cash needs as they arise 2. Activity ratios

 ratios that measure the liquidity of specific assets and efficiency in managing assets 3. Leverage ratios ratios that measure the extent of a firms financing, with debt relative to equity and its ability to cover interest and other fixed charges 4. Profitability ratios ratios that measure the overall performance of the firm and its efficiency managing assets, liabilities and equity 5. Market ratios ratios that measure investor response to owning a company's stock and also the cost of issuing stock