Financial Analytics Toolkit: Ratio Analysis

8 Pages Posted: 12 Oct 2019

See all articles by Marc L. Lipson

Marc L. Lipson

University of Virginia - Darden School of Business

Abstract

This note describes the most common financial ratios and how they provide insight into firm performance. The emphasis is on how ratios summarize operating behaviors and results in ways that facilitate interpretation and highlight decisions. There are three broad categories of ratios covered in the note: profitability, operating efficiency, and leverage (the use of debt financing). The note defines the ratios, explains how they provide insight, and explores complications related to their use. The concepts in this note are applied to the firm Morgan Industries, a setting that has been integrated across all the Financial Analytics Toolkit series of technical notes.

Excerpt

UVA-F-1897

Sept. 30, 2019

Financial Analytics Toolkit: Ratio Analysis

Ratio analysis provides insight into the performance of a firm, and ratios are often used in forecasting expected future performance. They summarize operating behaviors and results in ways that facilitate interpretation and highlight decisions. There are three broad categories of ratios: profitability, operating efficiency, and leverage (the use of debt financing). Most applications use line items directly from financial statements, although a few also use a firm's stock price. Many ratios link income statement amounts to balance sheet amounts. When doing so, one typically uses the end-of-year balance sheet amount associated with a given year's income statement amount.

Profitability Ratios

Profitability ratios evaluate the degree to which operations are providing an acceptable return on investmentĀ (ROI). The return can be evaluated relative to all investments (assets) or just to the investment made by shareholders (equity). A common framework for discussing firm profitability is the so-called DuPont decomposition. The elements of this framework are shown in Table 1.

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Keywords: ratio analysis, forecasting, operations, financial analytics

Suggested Citation

Lipson, Marc L., Financial Analytics Toolkit: Ratio Analysis. Darden Case No. UVA-F-1897. Available at SSRN: https://ssrn.com/abstract=3468747

Marc L. Lipson (Contact Author)

University of Virginia - Darden School of Business

P.O. Box 6550
Charlottesville, VA 22906-6550
United States

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