# Financial Math

Topics: Generally Accepted Accounting Principles, Financial ratios, Financial ratio Pages: 10 (1661 words) Published: June 22, 2013
5 Analyzing financial statements using ratios 0011 0010 1010 1101 0001 0100 1011 Generally there are two approaches in analyzing financial statements by use of ratios: 1. Common size percentages – where a key item in the financial statements is identified and then all the other items are expressed as a percentage of the item.

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Accounting and Reporting II

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1.4 Analyzing financial statements using ratios 0011 0010 1010 1101 0001 0100 1011 Common size percentage can be applied as follows: a) Other incomes and all expenses are expressed as a percentage of revenue. b) Different items or some totals for assets, liabilities and capital are expressed as a percentage of Total Assets. c) All items of cash receipts and payments are expressed as a percentage of say cash flows from operating activities.

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Accounting and Reporting II

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1.4 Analyzing financial statements using ratios 0011 0010 1010 1101 0001 0100 1011 2. Financial statements items The most popular method of analyzing financial statements is by relating financial statements items individually or as a group. In this case we identify five main categories of ratios as regards the income statement and the statement of financial position. These will be discussed in the next section

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Accounting and Reporting II

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1.4 Analyzing financial statements using ratios 0011 0010 1010 1101 0001 0100 1011 1. Liquidity ratios: These measure the ability of the firm to meet its short term maturing obligations. They focus mainly on current assets and current liabilities.

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The following are the main examples of liquidity ratios
Accounting and Reporting II 4

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1.4 Analyzing financial statements using ratios
Formula Current Assets Current Liabilities Explanation How many times the current assets cover current liabilities Considers that inventory may not be sold quickly To what extent the available cash cover current liabilities Remark The higher the better (about 2:1)

Ratio Current ratio

Acid test Current assets – Inventory Current liabilities ratio Cash ratio Cash + Short-term Fin. Assets Current liabilities

Again the higher the better ( about 1:1) Again the higher the better

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Accounting and Reporting II

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1.4 Analyzing financial statements using ratios 0011 0010 1010 1101 0001 0100 1011 2. Gearing or solvency ratios These measure the ability of the firm to meet its short-term and long-term maturing obligations. The ratios consider the overall risk of the business by considering the total funding especially from liabilities.

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Accounting and Reporting II

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1.4 Analyzing financial statements using ratios 0011 0010 1010 1101 0001 0100 1011 Ratio Formula Explanation Remark Debt ratio Total Liabilities Total Assets Measures the proportion of assets funded by liabilities The ratio of contribution by lenders to contribution by owners How many times interest can be paid from the profit The lower the ratio the better

Debt Equity

Total liabilities Total Equity

The lower the ratio the better the firm

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Interest coverage

EB Int & Tax Annual interest expense

The higher the coverage the better

Accounting and Reporting II

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1.4 Analyzing financial statements using ratios 0011 0010 1010 1101 0001 0100 1011 3. Profitability ratios These measure how profitable a business is in relation to sales and also the assets and the funding.

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Accounting and Reporting II

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1.4 Analyzing financial statements using ratios 0011 0010 1010 1101 0001 0100 1011 Ratio Gross profit margin Formula Gross profit Revenue Explanation Measures how much gross profit a business makes for every unit of sale Measures how profitable the business is especially in controlling operating expenses Measures the net profit for every of sale Accounting and Reporting II

Remark The higher the ratio the better

Operating profit margin

Profit before interest and tax Sales

The...