CHAPTER
3Ratio Analysis
I
n this chapter, we first review the basic concepts of ratio analysis. Ratio
analysis is a well-established set of calculated variables that can often pro-
vide a quick and accurate assessment of the operating condition and finan-
cial health of companies. The current assets (cash, receivables, inventory,
etc.) support the short-run operations of the business. We integrate current
asset management, sources and uses of funds (introduced in the previous
chapter), and ratio analysis in this chapter.
Ratio Analysis and the Firm’s Perceived Financial Health
Ratio analysis is an alternative to the flow of funds method of working cap-
ital analysis, although the two can be used to supplement each other. Ratio
analysis is older and possibly a more popular approach than the flow of
funds method of management, and is the tool most readily available to
credit managers of other companies, or other outsiders. A person within
the firm sometimes finds other analytical tools more useful.
Ratio analysis consists of studying ratio or percentage relationships of
meaningful financial data. The results are compared (1) with standard ra-
tios (i.e., the averages or median values of all firms or only similar firms);
(2) with the firm’s ratios in previous years; or (3) with some implicit stan-
dards existing in the mind of the analyst. In the hands of a skilled practi-
tioner both “external analysis” (comparisons to standard ratios) and
internal analysis (i.e., trends and relationships of the ratios within the com-
pany) can be revealing.
Innumerable ratios can be developed, since the financial accounts can
be placed in almost unlimited combinations. For most purposes, however,
about 13 popular ratios suffice for whatever can be learned from this
method about the firm’s current financial position.^1 In many cases only 6 to