Why ratios fluctuate over time and why they should be used with care.

Sample Solution

     

Key Financial Statements

The four key financial statements are:

• Balance sheet
• Income statement
• Cash flow statement
• Statement of shareholders' equity

Balance sheet

The balance sheet shows a company's financial position at a specific point in time. It lists the company's assets, liabilities, and shareholders' equity.

Full Answer Section

   

• Assets are resources that the company owns and expects to benefit from in the future.
• Liabilities are debts that the company owes to others.
• Shareholders' equity is the money that the company's owners have invested in the company.

The balance sheet equation is: Assets = Liabilities + Shareholders' Equity. Income statement The income statement shows a company's financial performance over a period of time, such as a quarter or a year. It lists the company's revenues, expenses, and net income.

• Revenues are the money that the company earns from selling its products or services.
• Expenses are the costs that the company incurs in order to generate revenue.
• Net income is the amount of money that the company has left over after paying all of its expenses.

The income statement equation is: Revenues - Expenses = Net Income. Cash flow statement The cash flow statement shows how much cash a company has generated and used over a period of time. It is divided into three sections: operating activities, investing activities, and financing activities.

• Operating activities include the cash flows that are generated from the company's core business operations.
• Investing activities include the cash flows that are generated from the purchase and sale of assets.
• Financing activities include the cash flows that are generated from the issuance and repayment of debt and equity.

Statement of shareholders' equity The statement of shareholders' equity shows the changes in a company's shareholders' equity over a period of time. It lists the changes in common stock, retained earnings, and other equity accounts.

• Common stock is the type of stock that is most commonly held by investors.
• Retained earnings are the profits that the company has kept after paying dividends to shareholders.
• Other equity accounts include other types of equity, such as preferred stock and treasury stock.

Financial Ratios Financial ratios are used to compare different aspects of a company's financial performance. They can be used to assess a company's profitability, liquidity, efficiency, and leverage. The five groups of financial ratios are:

• Profitability ratios: Profitability ratios measure how well a company is generating profits.
• Liquidity ratios: Liquidity ratios measure how well a company is able to meet its short-term financial obligations.
• Efficiency ratios: Efficiency ratios measure how well a company is using its resources.
• Leverage ratios: Leverage ratios measure how much debt a company has relative to its equity.
• Market value ratios: Market value ratios measure the value of a company's stock relative to its earnings and assets.

Examples of financial ratios Here are some examples of financial ratios:

• Profitability ratios: Return on assets (ROA), return on equity (ROE), net profit margin
• Liquidity ratios: Current ratio, quick ratio, cash ratio
• Efficiency ratios: Inventory turnover ratio, accounts receivable turnover ratio, total asset turnover ratio
• Leverage ratios: Debt-to-equity ratio, times interest earned ratio
• Market value ratios: Price-to-earnings ratio, price-to-book ratio

Relationship between ratios and financial statements Financial ratios are calculated using data from the balance sheet and income statement. For example, the current ratio, which is a liquidity ratio, is calculated by dividing current assets by current liabilities. The current assets and current liabilities are both listed on the balance sheet. Why ratios fluctuate over time Financial ratios can fluctuate over time due to a number of factors, such as changes in the company's business operations, changes in the industry, and changes in the overall economy. For example, if a company experiences a decline in sales, its profitability ratios will likely decline as well. Why ratios should be used with care Financial ratios should be used with care because they can be affected by a number of factors, such as accounting methods and industry benchmarks. It is important to compare a company's ratios to those of other companies in the same industry. It is also important to consider the company's historical ratios and to look for trends over time. Conclusion Financial ratios are a valuable tool for corporate managers and investors. They can be used to assess a company's financial performance and to make informed investment decisions. However, it is important to use ratios with care and to consider all of the relevant factors.