Unit 2 Financial Statement Ratios
Overview
Unit 2 will show how to use the 4 standard financial statements by calculating ratios that can then be used for analysis and comparison. Now that we have a better understanding of the significance of the 4 standard financial statements, we can now learn how to select and use certain numbers from them to determine the health of an organization.
We have taken the steps, thus far, to develop a knowledge of the basic accounting principles and how they are presented in the 4 standard financial statements. Then, we considered the elements of these statements, seeing a mild inter-relationship between them. Adding to this, we have explored web resources to find the financial statements of just about any publicly traded company. Now, with the varying statements in hand (or on screen), we are taking the next step to focus on the power of the inter-relationships of certain numbers that will be strong indicators of the financial position of an organization.
These numbers will then be used to form a series of ratios that can firmly denote the strengths (or weaknesses) of an organization. There is no clear answer as to which ratio, or handful of ratios, are best. Certain ratios will be favored by some, while other ratios will be favored by others; the particular need, or desired information, at the time may dictate which ratios are best to use.
This allows us to compare company to company, regardless of company size or product/service sold.
This unit’s exploration into ratios can drive organizational decision making, or maybe even be a part of our research for determining good (or bad) investments.
Learning Outcomes
When you have completed this unit, you should be able to:
- Calculate and apply the common ratios to determine an organization’s financial health.
- Assess the results of calculations to make meaningful comparisons between organizations.
Activity Checklist
Here is a checklist of learning activities you will benefit from in completing this unit. You may find it useful for planning your work.
Learning Activities
- Read The Accounting Game (TAG), chapter 4 (60 minutes)
- Complete the Ratio Calculation and Statement Comparison activity
Assessment
- In this course you demonstrate your understanding of the course learning outcomes in different ways, including papers, projects, discussions and quizzes. Please see the Assessment section in Moodle for assignment details and due dates.
Resources
Here are the resources you will need to complete this unit.
- Kline, G. and Dabney, A. ; (2013) The Cartoon Introduction to Statistics. New York: Hill and Wang
- 978-0-8090-3359-1
- (CIS)
- Mullis, D. and Orloff, J.; (1998) The Accounting Game. Naperville, Ill: Sourcebooks.
- 978-1-4022-1186-7
- (TAG)
- Other online resources will be provided in the unit.
Planning Ahead
Before you examine the topics in this unit, take a moment to watch this video that has been provided by the instructor. This video will introduce each topic and help support your learning. You are encouraged to re-watch this video if you are struggling with any of the concepts you will be learning about in this section.
Watch:FC_LDRS 220 Unit 4 Video
Activity: Read
To help you prepare for what you will be learning in this unit, read the following:
Chapter 4 from your The Accounting Game textbook
- This chapter detail key terms and definitions of line items found on the 4 Financial Statements. With this knowledge, you can then select the appropriate numbers from any set of financial statements and begin to calculate ratios. Your familiarity with all of the common ratios will allow you to select the best ratios to fit your given analysis. (There is no clear set of ratios to use EVERY time for EVERY analysis) - you will likely establish a few favorite ratios (this is not only okay, but preferred!).
- Most ratios fit into the categories of: Liquidity (Cash), Activity, Capitalization (Debt), and Profitability. It is prudent to select at least one ratio from each category.
- This chapter detail key terms and definitions of line items found on the 4 Financial Statements. With this knowledge, you can then select the appropriate numbers from any set of financial statements and begin to calculate ratios. Your familiarity with all of the common ratios will allow you to select the best ratios to fit your given analysis. (There is no clear set of ratios to use EVERY time for EVERY analysis) - you will likely establish a few favorite ratios (this is not only okay, but preferred!).
2.1 Using Financial Ratios for Analysis
In this unit, we learn how to bring all the information from the previous unit together to develop a meaningful “picture” of the health of an organization. The accounting equation is critical to understand the 4 standard financial statements. The components of the 4 standard financial statements provide a good view of organizational health. But, the use of these ratios reveal a very solid picture of the organization’s well-being. And to make this more powerful, the ratios can then be compared with other organizations, regardless of company size. In other words, smaller organizations can be directly compared to larger organizations.
As mentioned in the Overview, financial ratios can be used to determine the strengths and weaknesses of organization. While there are many different ratios that could be used to develop an overall “picture” of the health of an organization, the following video explains some of the most common ratios used to perform an analysis of the financial position of a company:
Watch: Top 10 Financial Ratios
The following video is intended to reinforce our analysis and comprehension of some of the common important business ratios:
Watch: Financial ratio analysis
Activity: Ratio Calculation and Statement Comparison
This activity will help support your understanding of Important Business Ratios. This activity is intended to provide practical application in the calculation of the common important business ratios.
In our last unit, we briefly mentioned how to find annual financial reports and search through them for important information. In this activity, you will use that knowledge to search for numbers to calculate important ratios used for evaluating the “health” of a company.
Prior to beginning this activity, download the MS Excel document titled “Financial Ratios.” This can be found on the “Resources” tab.
Consider each of the 5 Financial Statements in the .pdf files found in Moodle. These are taken from:
(You are VERY welcome to select other companies.)
Once you have identified your five companies, scroll through the annual reports until you find the 4 standard financial statements (Remember: the terms may vary, but the content is generally consistent. It will likely help to search (Cntrl+F) for key terms you learned in Unit 1.)
Next, using the “Financial Ratio” document (Excel file), enter a company’s data onto the “Ratio Worksheet” tab (into the orange fields). Consider the ratios (Column I) as you enter the data.
Note:
Copy this tab and repeat for the process for the other remaining 4 companies.
It may be worth noting to discover and denote if an organization’s financial statements are compliant to GAAP or IFRS (or both), especially in comparing ‘cash’ ratios. (It is best perform your comparisons if all in your analysis comply with the same set of rules/principles.)
Once you have completed your analysis, consider the following questions:
- Which company is the healthiest? And which is the weakest? (Be sure to explain WHY???)
- Which company would you invest in (based on EARNING POTENTIAL)?
Be prepared to defend your conclusions and share your thoughts with other members of the class.
Note: Learning activities in this course are ungraded, unless specified. They are designed to help you succeed in your assessments in this course, so you are strongly encouraged to complete them.
Assessment
Refer to the course schedule for graded assignments you are responsible for submitting. All graded assignments, and their due dates, can be found on the “Assessment” tab.
In addition to any graded assignments you are responsible for submitting, be sure to complete all the Learning Activities that have been provided throughout the content - these are intended to support your understanding of the content.