Horizontal Analysis or Trend Analysis:

Definition and Explanation of Horizontal or Trend Analysis:

Comparison of two or more year's financial data is known as horizontal analysis, or trend analysis.
Horizontal analysis is facilitated by showing changes between years in both dollar and percentage form.
CcO 1 COCCOcC CcCO11

Quite simply, the horizontal analysis is the financial statements of a company of successive years
presented side-by-side. The goal of horizontal analysis is to compare the figures of the current period
with that of the past period. This helps the company and its shareholders analyze their performance and
find out areas of improvement. Read on to know more about trend analysis.

Horizontal analysis is done for both income statements and balance sheets. The idea is the same. The
figures for the different heads under the income statements and the balance sheets are placed side-by-
side so that the reader can compare the two and understand how the company is doing. The horizontal
analysis also includes two more columns: the column denoting actual numerical change over two periods
and another denoting percentage change over the two periods. The first column gives the difference
between the past period and the current period, while the percentage column shows what percentage of
the past figure is the figure denoting the change. Read on for more on balance sheet analysis.

Horizontal analysis is an important part of the financial statements and annual reports. It places the
facts very simply in front of the shareholder and makes the job of analyzing the improvements or the
lack of it very simple for the shareholder. Horizontal analysis helps the shareholder understand the
change and the percentage change. And if there is no improvement or in fact a reduction, then the
board is compelled to explain the situation to the shareholder and what they intend to do in the future to
fix it. Read on for more on financial planning and budgeting to help you manage your costs better.
OOscC cC COCCOcC CcCO11 O sC
c-cC _-__
The two simplest ways to analyze your financial statements are vertically and horizontally. A vertical
analysis shows you the relationships among components of one financial statement, measured as
percentages. On your balance sheet, each asset is shown as a percentage of total assets; each liability
or equity item is shown as a percentage of total liabilities and equity. On your statement of profit and
loss, each line item is shown as a percentage of net sales.
A horizontal analysis provides you with a way to compare your numbers from one period to the next,
using financial statements from at least two distinct periods. Each line item has an entry in a current
period column and a prior period column. Those two entries are compared to show both the dollar
difference and percentage change between the two periods.
Vertical Analysis and Common Size Statements:
Definition and Explanation of Vertical Analysis and Common Size Statements:
Vertical analysis is the procedure of preparing and presenting common size statements.Common size
statement is one that shows the items appearing on it in percentage form as well as in dollar form.
Each item is stated as a percentage of some total of which that item is a part. Key financial changes and
trends can be highlighted by the use of common size statements.
Common size statements are particularly useful when comparing data from different companies.
Example: Balance Sheet
One application of the vertical analysis idea is to state the separate assets of a company as percentages
of total sales.
Income 6OcOCO
Another application of the vertical analysis idea is to place all items on the income statement in
percentage form in terms of sales.
C116sOCCcC CcCO11

What Does Cross-Sectional Analysis Mean?
A type of analysis an investor, analyst or portfolio manager may conduct on a company in relation to
that company's industry or industry peers. The analysis compares one company against the industry it
operates within, or directly against certain competitors within the same industry, in an attempt to
discover the best of the breed.

Investopedia explains Cross-Sectional Analysis
When conducting a cross-sectional analysis, the analyst seeks to identify, by using comparative metrics,
the valuation, debt-load, future outlook and/or operational efficiency of the target company. This allows
the analyst to evaluate the target company's efficiency in these areas, and to make the best investment
choice among a group of competitors or the industry as a whole.

When comparing the target firm to competitors, the analyst must be careful to consider the unique
operating characteristics of each company and how that will affect any comparative metrics used.

C116sOCCcC LcOC CcCO11

A method of analysis that compares a firm's ratios with some chosen industry benchmark.
The benchmark usually chosen is the average ratio value for all firms in an industry for the time period
under study.

The analysis of a financial ratio of a company with the same ratio of different companies in the same
industry. For example, one may conduct a cross-sectional ratio analysis of the debt ratios of multiple
companies in the telecommunications industry. Quite simply, one does this by taking the debt ratios of
each company and comparing them to one another. An analyst does this in order to find the company
with healthiest financial status. This is helpful in making informed investment decisions.


%CscCC-

Definition: Benchmarking is a tool used by financial analysts of all types, including (but not limited
to) controllers and securities analysts. It involves finding useful points of comparison for a company's or
a business unit's results, and putting them in the context of how peer companies are performing. Thus,
for example, a company's growth in revenues might be benchmarked against the growth experienced
over the same period by other companies in the same industry, of similar size and selling a similar mix
of products or services.
Also Known As: comparisons against peer groups.
Benchmarking is a process of comparing an organization's or company's performance to that of other
organizations or companies using objective and subjective criteria. The process compares programs and strategic
positions of competitors or exemplary organizations to those in the company reviewing its status for use as reference
points in the formation of organization decisions and objectives. Comparing how an organization or company
performs a specific activity with the methods of a competitor or some other organization doing the same thing is a
way to identify the best practice and to learn how to lower costs, reduce defects, increase quality, or improve
outcomes linked to organization or company excellence.
Organizations and companies use benchmarking to determine where inputs, processes, outputs, systems, and
functions are significantly different from those of competitors or others. The common question is, What is the best
practice for a particular activity or process? Data obtained are then used by the organization or company to introduce
change into its activities in an attempt to achieve the best practice standard if theirs is not best. Comparison with
competitors and exemplary organizations is helpful in determining whether the organization's or company's
capabilities or processes are strengths or weaknesses. Significant favorable input, process, and output benchmark
variances become the basis for strategies, objectives, and goals. Often, a general idea that improvement is possible is
the reason for undertaking benchmarking. Benchmarking, then, means looking for and finding organizations or
companies that are doing something in the best possible way and learning how they do it in order to emulate them.
Organizations or companies often attempt to benchmark against the best in the world rather than the best in their
particular industry.
A problem with benchmarking is it may restrict the focus to what is already being done. By emulating current
exemplary processes, benchmarking is a catch-up managerial tool or technique rather than a way for the organization
or company to gain managerial dominance or marketing share. Benchmarking can foster new ideas or processes when
management uses noncompetitive organizations or companies outside its own industry as the basis of benchmarking.
What if new ideas are not generated? It is possible that no one in some other organization or company has had a great
idea that is applicable to the input, process, or outcome that the organization is attempting to improve or change by
benchmarking.
Benchmarking is not a competitive analysis. Benchmarking is the basis for change. It is about learning. The
organization performing the benchmark analysis uses the information found in the process to establish priorities and
target process improvements that can change business or manufacturing practices. Benchmarking commonly takes
one of four forms.
Generic benchmarking investigates activities that are or can be used in most businesses. This type of
benchmarking makes the broadest use of data collection. One difficulty is in understanding how processes translate
across industries. Yet generic benchmarking can often result in an organization's drastically altering its ideas about its
performance capability and in the reengineering of business processes.
Functional benchmarking looks at similar practices and processes in organizations or companies in other
industries. This type of benchmarking is an opportunity for breakthrough improvements by analyzing high-
performance processes across a variety of industries and organizations.
Competitive benchmarking compares the organization's processes to those of direct competitors. In
competitive benchmarking, a consultant or other third party rather than the organization itself collects and analyzes
the data because of its proprietary nature.
Internal benchmarking compares processes or practices within the organization or company over time in light
of established goals. Advantages of internal benchmarking include the ease of data collection and the definition of
areas for future external investigations. The primary disadvantage of internal benchmarking is a lower probability that
it will yield significant process improvement breakthroughs.
Each form of benchmarking has advantages and disadvantages, and some are simpler to conduct that others.
Each benchmarking approach can be important for process analysis and improvement. Breakthrough improvements
are generally attributed to the functional and generic types of benchmarking.
Eight steps are typically employed in the benchmarking process.
y Identify processes, activities, or factors to benchmark and their primary characteristics.
y Determine what form is to be used: generic, functional, competitive, or internal.
y Determine who or what the benchmark target is: company, organization, industry, or process.
y Determine specific benchmark values by collecting and analyzing information from surveys, interviews,
industry information, direct contacts, business or trade publications, technical journals, and other sources of
information.
y Determine the best practice for each benchmarked item.
y Evaluate the process to which benchmarks apply and establish objectives and improvement goals.
y Implement plans and monitor results.
y Recalibrate internal base benchmarks.

A recurring problem that must be addressed during the eight steps is the determination of criteria to ensure that
inaccuracies or inconsistencies do not occur that will make any comparison meaningless.
The eight steps of the benchmarking process can be summarized as an improvement analysis. That is, the
organization investigates another organization to find out what it does and how it is done. During the investigation,
what goes right and what goes wrong is determined. This information is then used for the improvement of activities or
processes. When the activities and processes of the organization making the investigation are equal to or better than
the measurements found during the investigation, no change is warranted because the investigating organization has
the better practice.
Another view of benchmarking is as an organization gap analysis. The organization deter mines what it lacks in
terms of what it knows and how it does things. The shortfalls that initiate the gap analysis can be activities and
processes or they can be tactics and strategies. The organization must then determine what other organization is good
at doing those things that can be improved or changed for the better. A very systematic investigation is made of the
organization with the best practices to discover what is done, how it is done, how it is implemented, and how it fits
into the organization's operations. The findings of the systematic investigation then become the basis of revision or
modification for the organization doing the investigation.
Benchmarking efforts typically collect information on responsibilities, program design, operating facilities,
technical know-how, brand images, levels or integration, managerial talent, and cost or financial performance.
Financial or cost data are often the category of greatest concern because these are factors in the input, pro cessing,
and output activities of the organization or company.
Benchmarking is frequently referred to as a "wake-up call." Organizations and companies benchmark for many
reasons: They want to determine where they spend their time and how much value they add, or they are curious
about how they stack up against others. Through the knowledge gained by benchmarking, organizations and
companies redefine their roles, add more value, reduce costs, and improve performances.
The electronics industry has a unique style of benchmarking. Here benchmarking involves running a set of standard
tests on a system to compare its performance with that of others. That is, it is a tool for measuring the power and
performance of hardware and software systems and applications as well as the capacity of a system. There are four
categories of benchmarking in the electronics industry:
y An application-based benchmark runs real applications or parts of applications either in full or modified
versions.
y A synthetic benchmark emulates applications activity.
y A playback test uses logs of one type of system call (e.g., disk calls) and plays the calls back in isolation.
y An inspection test exercises a system or component to emulate an application activity.

The synthetic and playback benchmarks are used to get a rough idea of how a system or component performs. If
application-based benchmarks are available that match the application, they are used to refine the evaluation. The
inspection benchmarks are used to determine whether a system or component is functioning properly. These
benchmarks use a well-defined testing methodology based on real-world use of a computer system. They measure
performance in a deterministic and reproducible manner that allows the system administrator to judge the
performance and capacity of the system. Benchmarks provide a means of determining tuning parameters, reliability,
bottlenecks, and system capacity that can provide marketing and buying information.
Although benchmarking in the electronics industry is a testing mechanism or process, it, too, is a technique for
learning, change, and process improvement. Benchmarking is an effective way to ensure continuous improvement or
progress toward strategic goals and organizational priorities. A real benefit of benchmarking comes from the
understanding of processes and practices that permit a transfer of best practices or performances into the
organization. At its best, benchmarking stresses not only processes, quality, and output but also the importance of
identifying and understanding the drivers of the activities.


Benchmarking measures the effectiveness of business processes compared to industry standards. It is a
classic management tool that companies use to determine the profitability of their products and
services. While there are several forms of benchmarking, such as process or performance, financial
benchmarking is probably the relevant, because it measures the effectiveness of money spent on
operations.
1. The Facts
o Benchmarking takes broad segments of a company's operations and breaks them down in to small,
complete processes that can be measured for overall effectiveness. While benchmarking takes time and
detail to implement, it is one part of company's strategic management process to ensure industry
competitiveness.
Strategic Management
y Strategic management is the implementation and evaluation of certain goals or objectives a business
wants to achieve. In order to measure effectiveness, a business will use benchmarking to review smaller
processes or a large division. By starting with the small processes, businesses will discover deficiencies
quickly and determine how to correct them; in turn, this will make the entire division more competitive.
Financial Benchmarks
y Financial benchmarking examines monetary processes within business division to determine their
industry competitiveness. Some examples of financial benchmarks include: Does the company spend
above industry average for rent and utilities? How does the cost of materials compare to the industry?
Are employee salaries and benefits competitive with the rest of the industry?
In addition, financial ratios are helpful when reviewing divisions for effectiveness. For example, this
could mean figuring the ratio of sales of notebooks to desktop PCs against the benchmarks of industry
peers. Ratios should be tracked regularly to determine where fluctuations occur and what drives these
differences.
Benchmark Advantages
y Benchmarking provides quantitative results for business processes. Measuring the financial strengths
and weaknesses of a divisional process gives management a clear picture of whether goals have been
achieved. Another advantage of benchmarking is that it begins with smaller processes; once problems
are identified, they may be easier to change than an entire division process.
Benchmark Disadvantages
y Benchmarking is a very detailed process; breaking down divisions into a small, finite process is time-
consuming and labor-intensive, and can be rendered completely ineffective if done improperly.
Additionally, specific benchmark goals do not exist. A company must use benchmarks to determine if it
is competitive to rivals and within industry standards. Benchmarking is also a continuous process that
must be reviewed often to ensure that the information being gathered is still useful to the company.
Refining benchmarks is a managerial process that must occur to ensure bad measurements are not
being taken of division processes.
7 11
A time series is a collection of observations of well-defined data items obtained through repeated
measurements over time. For example, measuring the value of retail sales each month of the year
would comprise a time series. This is because sales revenue is well defined, and consistently measured
at equally spaced intervals. Data collected irregularly or only once are not time series.

An observed time series can be decomposed into three components: the trend (long term direction),
the seasonal (systematic, calendar related movements) and the irregular (unsystematic, short term
fluctuations).
Accounting Ratios | Financial Ratios:
Ratios simply means one number expressed in terms of another. A ratio is a statisticalyardstick by
means of which relationship between two or various figures can be compared or measured.
Definition of Accounting Ratios:
The term "accounting ratios" is used to describe significant relationship between figures shown on a
balance sheet, in a profit and loss account, in a budgetary control system or in any other part of
accounting organization. Accounting ratios thus shows the relationship between accounting data.
Ratios can be found out by dividing one number by another number. Ratios show how onenumber is
related to another. It may be expressed in the form of co-efficient, percentage, proportion, or rate. For
example the current assets and current liabilities of a business on a particular date are $200,000 and
$100,000 respectively. The ratio of current assets and current liabilities could be expressed as 2 (i.e.
200,000 / 100,000) or 200 percent or it can be expressed as 2:1 i.e., the current assets are two times
the current liabilities. Ratio sometimes is expressed in the form of rate. For instance, the ratio between
two numerical facts, usually over a period of time, e.g. stock turnover is three times a year.
Advantages of Ratios Analysis:
Ratio analysis is an important and age-old technique of financial analysis. The following are some of the
advantages / Benefits of ratio analysis:
1. Simplifies financial statements: It simplifies the comprehension of financial statements. Ratios
tell the whole story of changes in the financial condition of the business
2. Facilitates inter-firm comparison: It provides data for inter-firm comparison. Ratios highlight
the factors associated with with successful and unsuccessful firm. They also reveal strong firms
and weak firms, overvalued and undervalued firms.
3. Helps in planning: It helps in planning and forecasting. Ratios can assist management, in its
basic functions of forecasting. Planning, co-ordination, control and communications.
4. Makes inter-firm comparison possible: Ratios analysis also makes possible comparison of the
performance of different divisions of the firm. The ratios are helpful in deciding about their
efficiency or otherwise in the past and likely performance in the future.
5. Help in investment decisions: It helps in investment decisions in the case of investors and
lending decisions in the case of bankers etc.
Limitations of Ratios Analysis:
The ratios analysis is one of the most powerful tools of financial management. Though ratios are simple
to calculate and easy to understand, they suffer from serious limitations.
1. Limitations of financial statements: Ratios are based only on the information which has been
recorded in the financial statements. Financial statements themselves are subject to several
limitations. Thus ratios derived, there from, are also subject to those limitations. For example,
non-financial changes though important for the business are not relevant by the financial
statements. Financial statements are affected to a very great extent by accounting conventions
and concepts. Personal judgment plays a great part in determining the figures for financial
statements.
2. Comparative study required: Ratios are useful in judging the efficiency of the business only
when they are compared with past results of the business. However, such a comparison only
provide glimpse of the past performance and forecasts for future may not prove correct since
several other factors like market conditions, management policies, etc. may affect the future
operations.
3. Ratios alone are not adequate: Ratios are only indicators, they cannot be taken as final regarding
good or bad financial position of the business. Other things have also to be seen.
4. Problems of price level changes: A change in price level can affect the validity of ratios
calculated for different time periods. In such a case the ratio analysis may not clearly indicate the
trend in solvency and profitability of the company. The financial statements, therefore, be
adjusted keeping in view the price level changes if a meaningful comparison is to be made
through accounting ratios.
5. Lack of adequate standard: No fixed standard can be laid down for ideal ratios. There are no well
accepted standards or rule of thumb for all ratios which can be accepted as norm. It renders
interpretation of the ratios difficult.
6. Limited use of single ratios: A single ratio, usually, does not convey much of a sense. To make
a better interpretation, a number of ratios have to be calculated which is likely to confuse the
analyst than help him in making any good decision.
7. Personal bias: Ratios are only means of financial analysis and not an end in itself. Ratios have
to interpreted and different people may interpret the same ratio in different way.
8. Incomparable: Not only industries differ in their nature, but also the firms of the similar
business widely differ in their size and accounting procedures etc. It makes comparison of ratios
difficult and misleading.
Classification of Accounting Ratios:
Ratios may be classified in a number of ways to suit any particular purpose. Different kinds of ratios are
selected for different types of situations. Mostly, the purpose for which the ratios are used and the kind
of data available determine the nature of analysis. The variousaccounting ratios can be classified as
follows:

Classification of Accounting Ratios / Financial Ratios
(A)
Traditional Classification or
Statement Ratios
(B)
Functional Classification or
Classification According to Tests
(C)
Significance Ratios or Ratios
According to Importance
y Profit and loss account
ratios or revenue/income
statement ratios
y Balance sheet ratios or
position statement ratios
y Composite/mixed ratios or
inter statement ratios
y Profitability ratios
y Liquidity ratios
y Activity ratios
y Leverage ratios or long
term solvency ratios

y Primary ratios
y Secondary ratios

Financial-Accounting-Ratios Formulas:
This is a collection of financial ratio formulas which can help you calculate financial ratios in a given
problem.
Analysis of Profitability:
General profitability:
y Gross profit ratio = (Gross profit / Net sales) 100
y Operating ratio = (Operating cost / Net sales) 100
y Expense ratio = (Particular expense / Net sales) 100
y Operating profit ratio = (Operating profit / Net sales) 100
Overall profitability:
y Return on shareholders' investment or net worth = Net profit after interest and tax /
Shareholders' funds
y Return on equity capital = (Net profit after tax Preference dividend) / Paid up equity capital
y Earnings per share (EPS) ratio = (Net profit after tax Preference dividend) / Number of equity
shares
y Return on gross capital employed = (Adjusted net profit / Gross capital employed) 100
y Return on net capital employed = (Adjusted net profit / Net capital employed) 100
y Dividend yield ratio = Dividend per share / Market value per share
y Dividend payout ratio or pay-out ratio = Dividend per equity share / Earnings per share
Short Term Financial Position or Test of Solvency:
y Current ratio = Current assets / Current liabilities
y Quick or acid test of liquid ratio (for immediate solvency) = Liquid assets / Current liabilities
y Absolute liquid ratio = Absolute liquid assets / Current liabilities
Current Assets Movement, Efficiency or Activity Ratios:
y Inventory / Stock turnover ratio = Cost of goods sold / Average inventory at cost
y Debtors of receivables turnover ratios = Net credit sales / Average trade debtors
y Average collection period = (Trade debtors No. of working days) / Net credit sales
y Creditors or payables turnover ratio = Net credit purchase / Average trade creditors
y Average payment period = (Trade creditors No. of working days) / Net credit purchase
y Working capital turnover ratio = Cost of sales / Net working capital
Analysis of Long Term Solvency:
y Debt to equity ratio = Outsiders funds / Shareholders funds or External funds / Internal funds
y Ratio of long term debt to shareholders funds (Debt equity) = Long term debt / Shareholders
funds
y Proprietary of equity ratio = Shareholders funds / Total assets
y Fixed assets to net worth = Fixed assets after depreciation / Shareholders' funds
y Fixed assets ratio or fixed assets to long term funds = Fixed assets after depreciation / Total long
term funds
y Ratio of current assets proprietors' funds = Current assets / Shareholders' funds
y Debt service or interest coverage ratio = Net profit before interest and tax / Fixed interest charges
y Capital gearing ratio = Equity share capital / Fixed interest bearing funds
-COcCOO LcOC1
What Does Profitability Ratios Mean?
A class of financial metrics that are used to assess a business's ability to generate earnings as
compared to its expenses and other relevant costs incurred during a specific period of time. For most
of these ratios, having a higher value relative to a competitor's ratio or the same ratio from a
previous period is indicative that the company is doing well.
Investopedia explains Profitability Ratios
Some examples of profitability ratios are profit margin, return on assets and return on equity. It is
important to note that a little bit of background knowledge is necessary in order to make relevant
comparisons when analyzing these ratios.

For instances, some industries experience seasonality in their operations. The retail industry, for
example, typically experiences higher revenues and earnings for the Christmas season. Therefore, it
would not be too useful to compare a retailer's fourth-quarter profit margin with its first-quarter profit
margin. On the other hand, comparing a retailer's fourth-quarter profit margin with the profit margin
from the same period a year before would be far more informative.
Every firm is most concerned with its profitability. One of the most frequently used tools of financial
ratio analysis is profitability ratios which are used to determine the company's bottom line.
Profitability measures are important to company managers and owners alike. If a small business has
outside investors who have put their own money into the company, the primary owner certainly has
to show profitability to those equity investors.
Profitability ratios show a company's overall efficiency and performance. We can divide profitability
ratios into two types: margins and returns. Ratios that show margins represent the firm's ability to
translate sales dollars into profits at various stages of measurement. Ratios that show returns
represent the firm's ability to measure the overall efficiency of the firm in generating returns for its
shareholders.
/OOO LcOC1

What Does Liquidity Ratios Mean?
A class of financial metrics that is used to determine a company's ability to pay off its short-terms debts
obligations. Generally, the higher the value of the ratio, the larger the margin of safety that the
company possesses to cover short-term debts.

Investopedia explains Liquidity Ratios
Common liquidity ratios include the current ratio, the quick ratio and the operating cash flow ratio.
Different analysts consider different assets to be relevant in calculating liquidity. Some analysts will
calculate only the sum of cash and equivalents divided by current liabilities because they feel that they
are the most liquid assets, and would be the most likely to be used to cover short-term debts in an
emergency.

A company's ability to turn short-term assets into cash to cover debts is of the utmost importance when
creditors are seeking payment. Bankruptcy analysts and mortgage originators frequently use
the liquidity ratios to determine whether a company will be able to continue as a going concern.

A liquidity ratio measures a company's ability to pay its bills. The denominator of a liquidity ratio is the
company's current liabilities, i.e., obligations that the company must meet soon, usually within one year.
The numerator of a liquidity ratio is part or all of current assets. Perhaps the most common liquidity
ratio is the current ratio, or current assets/current liabilities. Because current assets are expected to be
converted to cash within one year, this liquidity ratio includes assets and liabilities of equal longevity.
The problem with the current ratio as a liquidity ratio is that inventories, a current asset, may not be
converted to cash for several months, while many current liabilities must be paid within 90 days. Thus a
more conservative liquidity ratio is the acid test ratio -- (current assets - inventory)/current liabilities --
which excludes relatively illiquid inventories. The most conservative liquidity ratio is the cash asset
ratio or the cash ratio, which includes only cash and cash equivalents (usually marketable securities) in
the numerator. Finally, note that the liquidity ratio sometimes means the cash ratio.

Total dollar value of cash and marketable securities divided by current liabilities. For a bank this is the
cash held by the bank as a proportion of deposits in the bank. The liquidity ratio measures the extent to
which a corporation or other entity can quickly liquidate assets and cover short-term liabilities, and
therefore is of interest to short-term creditors. also called cash asset ratio or cash ratio.

/Oc- LcOC

What Does Leverage Ratio Mean?
1. Any ratio used to calculate the financial leverage of a company to get an idea of the company's
methods of financing or to measure its ability to meet financial obligations. There are several different
ratios, but the main factors looked at include debt, equity, assets and interest expenses.

2. A ratio used to measure a company's mix of operating costs, giving an idea of how changes in output
will affect operating income. Fixed and variable costs are the two types of operating costs; depending on
the company and the industry, the mix will differ.

Investopedia explains Leverage Ratio
1. The most well known financial leverage ratio is the debt-to-equity ratio. For example, if a company
has $10M in debt and $20M in equity, it has a debt-to-equity ratio of 0.5 ($10M/$20M).

2. Companies with high fixed costs, after reaching the breakeven point, see a greater increase in
operating revenue when output is increased compared to companies with high variable costs. The reason
for this is that the costs have already been incurred, so every sale after the breakeven transfers to the
operating income. On the other hand, a high variable cost company sees little increase in operating
income with additional output, because costs continue to be imputed into the outputs. The degree of
operating leverage is the ratio used to calculate this mix and its effects on operating income.

sOOOO LcOC

What Does Activity Ratio Mean?
Accounting ratios that measure a firm's ability to convert different accounts within their balance sheets
into cash or sales.

Investopedia explains Activity Ratio
Companies will typically try to turn their production into cash or sales as fast as possible because this
will generally lead to higher revenues.

Such ratios are frequently used when performing fundamental analysis on different companies. The
asset turnover ratio and inventory turnover ratio are good examples of activity ratios.

sOOOO cOC

An indicator of how rapidly a firm converts various accounts into cash or sales. In general, the sooner
management can convert assets into sales or cash, the more effectively the firm is being run.





6OcO C O CcCscC LcOC1
How They Are Calculated and What They Show
Profitability Ratios
1. Gross profit margin Sales - Cost of goods sold
Sales
An indication of the total margin available to cover operating expenses and yield a profit.
2. Operating profit margin
(or Return on Sales)
Profits before taxes and interest
Sales
An indication of the firm's profitability from current operations without regard to the interest charges
accruing from the capital structure
3. Net profit margin (or net
Return on sales)
Profits after taxes
Sales
Shows after tax profits per dollar of sales. Subpar profit margins indicate that the firm's sales prices are
relatively low or that costs are relatively high, or both.
4. Return on total Assets Profits after taxes
Total assets
or Profits after taxes + interest
Total assets
A measure of the return on total investment the enterprise. It is sometimes desirable to add interest to
after
tax profits to form the numerator of the ratio since total assets are financed by creditors as well as by
stockholders; hence, it is accurate to measure the productivity of assets by the returns provided to both
classes of investors.
5. Return on stockholder's
equity (or return on net
worth)
Profits after taxes
Total stockholders' equity
A measure of the rate of return on stockholders' investment in the enterprise.
6. Return on common
equity
(Profits after taxes -Preferred stock dividends)
(Total stockholders" equity - Par value of preferred stock)
A measure of the rate of return on the investment the owners of the common stock have made in the
enterprise. More commonly referred to as "return on equity" or ROE.
7. Earnings per share (Profits after taxes - Preferred stock dividends)
Number of shares of common Stock outstanding
Shows the earnings available to the owners of each share of common stock.Liquidity Ratios
1. Current ratio Current assets
Current liabilities
Indicates the extent to which the claims of short-term creditors are covered by assets that are expected
to be
converted to cash in a period roughly corresponding to the maturity of the liabilities.
2. Quick ratio (or acid-test
ratio)
(Current assets-Inventory)
Current Liabilities
A measure of the firm's ability to pay off short-term obligations without relying on the sale of its
inventories.
3. Inventory to net working
capital
Inventory
(Current assets - Current Liabilities)
A measure of the extent to which the firm's working capital is tied up in inventory.
Leverage Ratios
1. Debt-to-assets ratio Total debt
Total assets
Measures the extent to which borrowed funds have been used to finance the firm's operations.
2. Debt-to-equity ratio Total debt
Total stockholders' equity
Provides another measure of the fund provided by creditors versus the funds provided by owners.
3. Long-term debt-toequity ratio
Long-term debt
Total shareholders' equity
A widely used measure of the balance between debt and equity in the firm's long-term capital structure.
4. Times-interest-earned
(or coverage) ratio
Profits before interest and taxes
Total interest charges
Measures the extent to which earnings can decline without the firm becoming unable to meet its annual
interest costs.
5. Fixed-charge coverage (Profits before taxes and interest + Lease obligations)
(Total interest charges + Lease obligations)
A more inclusive indication of the firm's ability to meet all of its fixed-charge obligations.Activity Ratios
1. Inventory turnover Sales
Inventory of finished goods
When compared to industry averages, it provides an indication of whether a company has excessive or
perhaps inadequate finished goods inventory.
2. Fixed assets turnover Sales
Fixed Assets
A measure of the sales productivity and utilization of plant and equipment.
3. Total assets turnover Sales
Total Assets
A measure of the utilization of all the firm's assets; a ratio below the industry average indicates the
company
is not generating a sufficient volume of business, given the size of its asset investment.
4. Accounts receivable
turnover
Annual credit sales
Accounts receivable
A measure of the average length of time it takes the firm to collect the sales made on credit
5. Average collection period Accounts receivable
(Total sales / 365)
or Accounts receivable
Average daily sales
Indicates the average length of time the firm must wait after making a sale before it receives payment.
This
has implications for financial management and quality of customers (marketing).
Other Ratios
1. Dividend yield on
common stock
Annual dividends per share
Current market price per share
A measure of the return to owners received in the form of dividends.
2. Price-earnings ratio Current market price per share
After tax earnings per share
Faster-growing or less-risky firms tend to have higher price-earnings ratios than slower growing or
morerisky firms.
3. Dividend payout Annual dividends per share
After-tax earnings per share
Indicates the percentage of profits paid out as dividends.4. Cash flow per share (After tax profits +
Depreciation)
Number of common shares outstanding
A measure of the discretionary funds over and above expenses that are available for use by the firm.
Ratio analysis is a useful way of gaining a "snapshot" picture of a company. These ratios can be
analyzed to identify the company's strengths and weaknesses and useful insights can be gained through
the process.
Very Important: However, it is important to realize this fact: the ratios have no financial theory
behind them. Theory tells us what SHOULD BE the case (or value). With financial ratios, we have no
way to identify a "theoretically best" value for any of the ratios. In fact, financial ratios are nothing
more than common sense measures that have been developed and evolved over time. As such, they
are imperfect measures and should be treated as such.
Use of the Ratios
When using ratios, think of yourself as a detective who is looking for clues (like the little guy at the top
of the page). Typically, ratios are excellent devices for uncovering clues about a company's financial
condition - but remember that clues simply raise more questions, not give definite answers. Ratios tell
us where to focus our attention and to ask relevant questions. We never want to depend of just one
ratio to draw a conclusion, the ratios are complementary and one ratio can be used to confirm a
suspicion raised by another ratio's value. It is only after looking at a variety of different ratios that a
picture of the company's financial condition begins to form.
Types of Ratios
Financial ratios are generally grouped together by their purpose. Although there are many of these
classifications, the most commonly used groups are:
1. Liquidity
2. Debt (or Leverage)
3. Activity (or Turnover)
4. Profitability
Typically, you would not calculate the ratios in all of these categories for a single company. Usually, you
would approach the ratio analysis from the perspective of an individual interested in one particular area.
For example, assume that you show up for work one day and see a letter on your desk. In the letter, a
company named Dragon Celebrations, Inc., orders $30,000 of merchandise from you on standard credit
terms (which gives them up to 30 days to pay for the order). Accompanying the letter is a set of audited
financial statements for the company. You're not familiar with Dragon Celebrations and don't have a
previous business relationship with it. Should you ship the merchandise to them?
Before doing so, you would like to determine the probability that they will pay you. You can purchase the
credit rating for the company from a credit bureau or standard credit reporting agency. However, if you
decide to do the analysis yourself, you can calculate the liquidity ratios using the company's balance
sheet information. These ratios will evaluate the liquidity of the business and should offer valuable
information as to the likelihood that Dragon will pay you within the 30 day period.
Who Uses the Ratios?
Although generalizations are difficult here, here are some of the key users for the different types of
ratios:
1. Liquidity - short-term creditors
2. Debt - existing lenders or potential lenders
3. Activity - top management of the company
4. Profitability - both existing and potential investors in the company's common stock
Additional details on these classifications may be found on the "Commonly Used Ratios" handout shown
below.
Major Ratios
Here is a handout that shows eleven basic, commonly used ratios and their construction. The second
part of the handout describes nine more ratios that you may encounter, although they are not as
common as the previous group.
Commonly Used Ratios
Although there are approximately 50 ratios that are used in practice, the ratios found on this handout
are used across a wide variety of industries and are a part of virtually any thorough financial analysis of
a company.
Ratio Analysis on the Web
Here is my favorite web site for looking up the value of companies' financial ratios and the industry
average for each ratio. It's a great site for financial analysis of companies.
After going to the company's homepage (see the link below), point to the "News and Markets" heading
at the top of the screen. A sub-menu will pop up; under the "Markets" heading, click on "Stocks." On
the next page's Search box, type in the ticker symbol for the company that you want to look up. (If you
don't know the ticker symbol, type in the company name and press Search. The next page will allow
you to type in the full company name.) When the company's screen appears, click on the box for
"Financials." You will then see a side-by-side comparison (for the company, industry, sector, and S&P
500) of all the major ratios. It makes an analysis easy and convenient.
Reuters
How Do We Use the Ratios?
There are two primary ways to use financial ratios:
1. Compare a ratio's value over several periods of time (trend analysis or time-series analysis). If
we see a deteriorating trend in any ratio's values over several quarters or years, we can
investigate to find the cause.
2. Compare the company's ratios to the industry average (cross-sectional analysis). A single ratio
value by itself usually means nothing - we need a standard, orbenchmark, to compare it to. This
benchmark is usually the industry average (i.e., the ratio's average value for all firms in the
industry).
There are some people who believe that the industry average should not be used - that this means that
we are trying to be average (mediocre). They advocate that we should compare our ratios to those of
the leading firm in the industry and try to match the ratios of that company. Although this argument
has a certain plausibility, it ignores the fact that the leading firm often has strengths that others in the
industry will have trouble meeting (outstanding marketing, superior management training programs,
etc.). The industry average is probably a more useful standard. After all, we aren't trying
to match these ratios; we are trying to exceed the average company's performance.
A Sample Comparison of Ratios
Click on the link to see a sample financial statement analysis for the restaurant industry.
A Particularly Useful Technique
A company's Return On Equity (ROE) ratio is one of the most commonly used ratios since it measures
exactly what investors want to know - how much the company is earning on every dollar that investors
put into the company. A particularly useful technique is to conduct a DuPont analysis on the company,
i.e., break down ROE into the sources of those profits. Do the profits come from effective marketing
techniques, strong control of costs, and effective pricing (all highly desirable) or do they come from the
company's high use of debt (a less desirable and riskier way of increasing profits)?
Cautions About Using Ratios
When using ratios as a form of analysis, be very careful that you don't put more trust in them than they
deserve. After all, they are simply common sense measures with no financial theory underlying them.
In fact, ratios have significant problems associated with them that should cause us to use them with
caution:
1. Ratios don't prove that a problem exists or provide definite answers to any of our
questions. However they are very good at providing us with some guidance on the future steps
that our investigation should take. In other words, a ratio analysis indicates symptoms of a
problem and focuses our attention onpotential problems that deserve our attention. But they
rarely provide us with firm answers; usually, the best that they do is tell us what key questions
we need to ask.
2. Realize that there may be significant differences between the characteristics of the
company and the "average" firm in the industry. For example, you may be analyzing the
financial statements of a steel manufacturer and want to compare the firm's ratios to the the
industry average. However, while primarily steel manufacturers, some of the other firms in the
industry may own their own captive finance companies, own railroad lines for transportation of
the finished steel, and own an insurance company for diversification purposes. It is often very
difficult to honestly say that we are comparing apples with apples when the companies in the
industry have substantially different structures and characteristics.
3. Always make sure that you are calculating a ratio exactly as the industry average ratio
is calculated. There are many variations on how to calculate the various ratios. For example, if
you look in several finance textbooks, you can easily find differences in suggested ways to
calculate Return on Investment, Inventory Turnover, and the Quick (or Acid Test) Ratio. Since
we typically depend on an outside firm (e.g., Reuters, Dun & Bradstreet, etc.) to provide us with
the values of the industry average for each ratio, we need to ensure that the formula that we are
using for a ratio is the same formula that the industry average source is using. For example, we
may calculate the Inventory Turnover ratio as (Cost of Goods Sold)/(Average Monthly
Inventory) while the outside source calculates it as (Annual Sales)/(Year Ending Inventory). Both
versions are commonly used.
4. Companies frequently don't have the same fiscal year. Some companies' fiscal year ends
on December 31st, others' end on September 30th, others' end on June 30th, etc.. If you are
depending on the year-ending (end of the fiscal year) balance sheet's data, this date may vary
widely among firms in the same industry. This is especially true of companies whose sales are
highly seasonal. For example, two companies who manufacture snowmobiles may have almost
identical performance numbers for the year. However, they will have vastly different inventory
and accounts receivable levels if one's year ends in June and the other's ends in December,
resulting in considerable differences in the values of a ratio analysis.
5. Companies' accounting practices may differ considerably. Companies have a great deal of
discretion in their accounting procedures, particularly with regard to depreciation (straight line,
double declining balance, etc.) and inventory (LIFO, FIFO, etc.). This makes comparisons more
difficult.
6. Be careful about depending too much on any one ratio. A ratio analysis is most valuable
when we evaluate a number of ratios of a certain type (liquidity, profitability, etc.) and look for a
pattern in the results.
7. Audited financial statements should be used whenever possible. Small businesses'
financial statements are often unaudited and may not be accurate.