Introduction to Corporate Finance

Ross et al.: Fundamentals

of Corporate Finance, Sixth

Edition, Alternate Edition

II. Financial Statements

and Long−Term Financial

Planning

3. Working with Financial
   Statements

(^94) © The McGraw−Hill
Companies, 2002
RATIO ANALYSIS
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. Us-
ing 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 num-
ber divided by another, and because there is a substantial quantity of accounting num-
bers 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 ra-
tios. 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 con-
cerned. 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.
62 PART TWO Financial Statements and Long-Term Financial Planning

TABLE 3.7

PRUFROCK CORPORATION

Summary of Standardized Balance Sheets

(Asset side only)

Combined

Assets Common-Size Common–Base Common-Size

($ in millions) Assets Year Assets and Base-Year Assets

2001 2002 2001 2002 2002 2002

Current assets

Cash $ 84 $ 98 2.5% 2.7% 1.17 1.08

Accounts receivable 165 188 4.9 5.2 1.14 1.06

Inventory 393 422 11.7 11.8 1.07 1.01

Total current assets $ 642 $ 708 19.1 19.7 1.10 1.03

Fixed assets

Net plant and equipment $2,731 $2,880 80.9 80.3 1.05 0.99

Total assets $3,373 $3,588 100.0% 100.0% 1.06 1.00

The common-size numbers are calculated by dividing each item by total assets for that year. For example, the 2001 common-size cash

amount is $84/3,373 2.5%. The common–base year numbers are calculated by dividing each 2002 item by the base-year (2001) dollar

amount. The common-base cash is thus $98/84 1.17, representing a 17 percent increase. The combined common-size and base-year

figures are calculated by dividing each common-size amount by the base-year (2001) common-size amount. The cash figure is therefore

2.7%/2.5% 1.08, representing an 8 percent increase in cash holdings as a percentage of total assets. Columns may not total precisely

due to rounding.

3.3

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