study undertaken by financial statement preparers and users to evaluate the financial strength or weakness of a company and its operating trend. Various ratios are computed, depending upon the objective of the user analyzing the financial statements. Short-term creditors are primarily concerned with a company’s ability to meet short-term debt from current assets, so they concentrate on the liquidity ratio emphasizing cash flow. Long-term creditors want to be paid back in the long term, so they look to solvency ratios such as total debt to total stockholders’ equity. Potential investors are interested in dividends and appreciation in market price of stock, so they focus on profitability ratios (e.g., profit margin) and market measures (e.g., price-earnings ratio). Auditors zero in on the going concern of the client by determining its ability to meet debt (e.g., interest coverage ratio). Also, auditors wanting to know where to concentrate their audit attention look for illogical relationships in accounts over time such as the ratio of promotion and entertainment expense to sales. The limitations of financial ratios for analytical purposes must be considered, including: (1) a ratio is static in nature and does not reveal future flows; (2) a ratio does not reveal the amount of its components (e.g., a current ratio figure does not tell you how much is in cash or inventory); (3) a ratio does not reveal the quality of its components (e.g., a high current ratio that is made up of poor quality receivables and obsolete inventory); and (4) a ratio is based on historical cost not taking into account inflation.
- Banking: detailed examination of a bank’s financial performance versus similar size banks, as indicated by its return on assets, return on equity, efficiency ratio (non-interest expense divided by revenue),loan charge-off ratio, earnings per share, net interest margin, noninterest income, and other criteria. Sources of information include bank annual reports, call report data reported to bank regulatory agencies, and Form 10K and Form 10Q reports submitted to the Securities and Exchange Commission. See also uniform bank performance report.
Ratio analysis examines performance and overall profitability of banks and bank holding companies. The four general categories ofratios in assessing performance of banks and bank holding companies include: profitability- Return On Assets (ROA), Return On Equity (ROE); capital- capital ratio; liquidity- liquidity ratios; and asset risk ratio-risk adjusted capital ratio. See also camels rating
- Commercial Lending:financial ratios used by commercial lenders in analyzing the financial condition of prospective and current borrowers. Trade ratios comparing performance by different firms in specific industries are available from the Robert Morris Associates, the national association of bank credit officers, the U.S. Department of Commerce, and other sources. See also balance sheet ratios
method of analysis, used in making credit and investment judgments, utilizes the relationship of figures found in financial statements to determine values and evaluate risks and compares such ratios to those of prior periods and other companies to reveal trends and identify eccentricities.
method of analysis, used in making credit and investment judgments, which utilizes the relationship of figures found in financial statements to determine values and evaluate risks and compares such ratios to those of prior periods and other companies to reveal trends and identify eccentricities. Ratio analysis is only one tool among many used by analysts.