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Index of concepts
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Subject: Investment Analysis
Chapter/Topic: Financial statement analysis
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Concept Definition and Explanation
The line items in financial statements in isolation convey little meaning. hence analysts calculate ratios from line items of financial statements and compare ratios over time, across companies and with some standard ratios considered as ideal.
Reilly and Brown divided financial rations into five major categories. These categories capture the important economic characteristics of a firm.
1. Common size statements.
2. Internal liquidity
3. Operating performance
4. Risk analysis
5. Growth analysis
1. Common Size Statements.
In common size balance sheet all accounts/line items are expressed as a percentage of total assets. Hence one can compare statements of different sized firms for their composition of assets and liabilities.
In common size income statements all line items are expressed as percentage of sales.
2. Internal Liquidity
This category of ratios compare near-term financial obligations such as accunts payable and notes payable to current assets or cash flows that will be available to meet these obligations.
3. Operating Performance
Two subcategories are used in this category. Efficiency ratios calculate the ratio of dollars of sales generated to various asset or capital categories. Profitability ratios analyze the profits as a percentage of sales and as a percentage of assets and capital employed.
4. Risk Analysis
This set of ratios examine the factors that cause a firm's net income to vary.
5. Growth Analysis
The important measure in this category is sustainable growth rate
g = Percentage of Ernings Retained * Return on Equity
g = RR * ROE
References:
Reilly, Frank and Keith Brown, Investment Analysis and Portfolio Management, 7th Edition, Thomson-South Western, 2003
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