## Ratio Analysis

financial ratios

Relationships determined from a firm's financial information and used for comparison purposes.

Another way of avoiding the problems involved in comparing companies of different sizes is to calculate and compare financial ratios. Such ratios are ways of comparing and investigating the relationships between different pieces of financial information. Using ratios eliminates the size problem because the size effectively divides out. We're then left with percentages, multiples, or time periods.

There is a problem in discussing financial ratios. Because a ratio is simply one number divided by another, and because there is a substantial quantity of accounting numbers out there, there is a huge number of possible ratios we could examine. Everybody has a favorite. We will restrict ourselves to a representative sampling.

In this section, we only want to introduce you to some commonly used financial ratios. These are not necessarily the ones we think are the best. In fact, some of them may strike you as illogical or not as useful as some alternatives. If they do, don't be concerned. As a financial analyst, you can always decide how to compute your own ratios.

What you do need to worry about is the fact that different people and different sources seldom compute these ratios in exactly the same way, and this leads to much confusion. The specific definitions we use here may or may not be the same as ones you have seen or will see elsewhere. If you are ever using ratios as a tool for analysis, you should be careful to document how you calculate each one, and, if you are comparing your numbers to numbers from another source, be sure you know how those numbers are computed.

We will defer much of our discussion of how ratios are used and some problems that come up with using them until later in the chapter. For now, for each of the ratios we discuss, we consider several questions that come to mind:

1. How is it computed?

2. What is it intended to measure, and why might we be interested?

3. What is the unit of measurement?

4. What might a high or low value be telling us? How might such values be misleading?

5. How could this measure be improved?

Financial ratios are traditionally grouped into the following categories:

1. Short-term solvency, or liquidity, ratios

2. Long-term solvency, or financial leverage, ratios

3. Asset management, or turnover, ratios

### 5. Market value ratios

We will consider each of these in turn. In calculating these numbers for Prufrock, we will use the ending balance sheet (2002) figures unless we explicitly say otherwise. Also notice that the various ratios are color keyed to indicate which numbers come from the income statement and which come from the balance sheet.

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