Accounting and Finance Foundations

Unit 11

Accounting and Finance Foundations Unit 11: Financial Analysis 827

Financial Analysis

Chapter 23

The current ratio, which is the ratio of current assets to current liabilities, represents the number of

times a company can pay current debts through current assets such as cash. It focuses on a business’s

solvency—the ability to pay back debt. As such, it is a measure of a company’s liquidity (the ability to turn

non-cash assets into assets) and ability to meet future obligations (pay future debts). A current ratio of less

than one is an indication that the company may default or not pay on its debt obligations, while a current

ratio of more than two can indicate that the company has too much cash or unused inventory on hand.

Current Ratio (#) = Current Assets / Current Liabilities

The return on assets (ROA) can be found by expressing the net income or profit as a percentage of total

assets. For example, if a company has an ROA of 10%, the company generates a net income equivalent to

10% of its assets. Another way to look at the return on assets is as a measure of net income produced by a

company’s assets. ROA is a measure of an asset’s or a company’s efficiency and profitability.

Return on Assets (ROA) (%) = Net Income / Total Assets

The inventory turnover is the number of times a company sells its inventory in a year. It is the primary

measure of a company’s ability to sell or “move” inventory. A low inventory ratio can be an indication of

slow sales and excess inventory, while a high inventory level can also be a sign of trouble—because rapid

inventory turnover can result in sales losses due to inventory shortages. Companies typically compare their

inventory turnover ratio with other companies within their industry.

Inventory Turnover = Cost of Goods Sold / Average Inventory

or

Inventory Turnover = Sales / Inventory

The earnings per share (EPS) is a measure of how much profit is allocated to each outstanding share of

common stock. In other words, EPS is an indicator of a company’s profitability. It can be calculated in a

couple of different ways: either by dividing net earnings by the number of outstanding shares of common

stock or by dividing the difference between net income and the dividends on preferred stock by the average

number of outstanding shares. Over time, an increasing EPS implies that the company is well run.

Earnings Per Share ($) = Net Earnings / # of Shares Outstanding

or

Earnings Per Share ($) = (Net Income – Dividends on Preferred Stock) / Average Outstanding Shares

The price-earnings ratio (PE) is a valuation of a company’s current share price compared to its earnings

per share. Many investors and analysts pay close attention to the PE ratio because it gives an indication of

whether a stock is overvalued or undervalued. A PE ratio that is higher than the industry average means

that investors expect the company to grow and be quite profitable. However, a PE ratio that is lower than

the industry average means that investors have low expectations for performance.

Price-Earnings Ratio (PE) = Stock Price / Earnings Per Share

Lesson 23.3 Key Performance Indicators &

Industry Comparison (cont’d)

Student Guide