2: Financial Statement and Cash Flow Analysissoftware business. Therefore, when making subjective judgements about the health of a given company,
analysts usually compare the company’s ratios to two benchmarks. First, they compare the financial
ratios in the current year with previous years’ ratios. In doing so, they hope to identify trends that will
aid in evaluating the company’s prospects. Second, they compare the ratios of one company with those
of other benchmark companies in the same industry (or to an industry average obtained from a trade
association or third-party provider).
We will use the 2016 and 2015 balance sheets and income statements for Global Petroleum
Corporation, presented earlier in Tables 2.1 and 2.2, to demonstrate ratio calculations. (To simplify
the presentation, we have deleted the millions after GPC’s values.) The ratios presented in this chapter
can be applied to nearly any company. Of course, many companies in different industries use ratios that
focus on aspects peculiar to their industry.^5 We shall cover the most common financial ratios, which are
grouped into five categories: liquidity, activity, debt, profitability and market ratios.^5
2-3b LIQuIDITY rATIOS
Liquidity ratios measure a company’s ability to satisfy its short-term obligations as they come due. Because
a common precursor to financial distress or bankruptcy is low or declining liquidity, liquidity ratios are
good leading indicators of cash flow problems. The two basic measures of liquidity are the current ratio
and the quick (acid-test) ratio.
The current ratio, one of the most commonly cited financial ratios, measures the company’s ability to
meet its short-term obligations. It is defined as current assets divided by current liabilities. The current
ratio presents in ratio form what net working capital measures by subtracting current liabilities from current
assets. The current ratio for GPC on 30 June 2016 is computed as follows:
Currentratio===
Currentassets
Currentliabilities$2,879
$2,614- 10
How high should the current ratio be? The answer depends on the type of business and on the
costs and benefits of having too much versus not enough liquidity. For example, a current ratio of 1.0
may be acceptable for an energy supply company, but unacceptably low for a manufacturer requiring
more liquidity. The more predictable a company’s cash flows, the lower the acceptable current ratio.
Because the business of oil exploration and development has notoriously unpredictable annual cash
flows, GPC’s current ratio of 1.10 indicates that the company takes a fairly aggressive approach to
managing its liquidity.
The quick (acid-test) ratio is similar to the current ratio, except that it excludes inventory, which is
usually the least-liquid current asset. The generally low liquidity of inventory results from two factors.
First, many types of inventory cannot be easily sold because they are partially completed items, special-
purpose items, and the like. Second, inventory is typically sold on credit, so it becomes an account
receivable before being converted into cash. The quick ratio is calculated as follows:
=
−
=−
Quickratio =
Currentassets Inventory
Currentliabilities$2,879 $615
$2,6140.866
The quick ratio for GPC in 2016 is 0.866.
5 For example, Qantas, an airline, would pay close attention to the ratio of revenues to passenger miles flown. Retailers such as Woolworths
and Coles diligently track the growth in same-store sales from one year to the next.
liquidity ratios
Measure a company’s ability
to satisfy its short-term
obligations as they come due
current ratio
A measure of a company’s
ability to meet its short-term
obligations, defined as current
assets divided by current
liabilities
net working capital
A measure of a company’s
liquidity calculated by
subtracting current liabilities
from current assetsquick (acid-test) ratio
A measure of a company’s
liquidity that is similar to the
current ratio except that it
excludes inventory, which is
usually the least-liquid current
asset