Financial Ratios Based on the

Balance Sheet
Financial statement analysis includes financial ratios. Here are three financial ratios that are
based solely on current asset and current liability amounts appearing on a company's balance
sheet:

Four financial ratios relate balance sheet amounts for Accounts Receivable and Inventory to
income statement amounts. To illustrate these financial ratios we will use the following income
statement information:
To learn more about the income statement, go to:

Explanation of Income Statement

Quiz for Income Statement
Crossword Puzzle for Income Statement
The next financial ratio involves the relationship between two amounts from the balance sheet:
total liabilities and total stockholders' equity:
General Discussion of Income
Statement
The income statement has some limitations since it reflects accounting principles. For example, a
company's depreciation expense is based on the cost of the assets it has acquired and is using
in its business. The resulting depreciation expense may not be a good indicator of the economic
value of the asset being used up. To illustrate this point let's assume that a company's buildings
and equipment have been fully depreciated and therefore there will be no depreciation expense
for those buildings and equipment on its income statement. Is zero expense a good indicator of
the cost of using those buildings and equipment? Compare that situation to a company with new
buildings and equipment where there will be large amounts of depreciation expense.

The remainder of our explanation of financial ratios and financial statement analysis will use
information from the following income statement:
To learn more about the income statement, go to:

Explanation of Income Statement

Quiz for Income Statement
Crossword Puzzle for Income Statement

Common-Size Income Statement

Financial statement analysis includes a technique known as vertical analysis. Vertical analysis
results in common-size financial statements. A common-size income statement presents all of
the income statement amounts as a percentage of net sales. Below is Example Corporation's
common-size income statement after each item from the income statement above was divided by
the net sales of $500,000:
The percentages shown for Example Corporation can be compared to other companies and to
the industry averages. Industry averages can be obtained from trade associations, bankers, and
library reference desks. If a company competes with a company whose stock is publicly traded,
another source of information is that company's "Management's Discussion and Analysis of
Financial Condition and Results of Operations" contained in its annual report to the Securities
and Exchange Commission (SEC). This annual report is the SEC Form 10-K and is usually
accessible under the "Investor Relations" tab on the corporation's website.

Financial Ratios Based on the Income

Statement
Statement of Cash Flows
The statement of cash flows is a relatively new financial statement in comparison to the income
statement or the balance sheet. This may explain why there are not as many well-established
financial ratios associated with the statement of cash flows.

We will use the following cash flow statement for Example Corporation to illustrate a limited
financial statement analysis:
The cash flow from operating activities section of the statement of cash flows is also used by
some analysts to assess the quality of a company's earnings. For a company's earnings to be of
"quality" the amount of cash flow from operating activities must be consistently greater than the
company's net income. The reason is that under accrual accounting, various estimates and
assumptions are made regarding both revenues and expenses. When it comes to cash, however,
the money is either in the bank or it isn't.

To learn more about the statement of cash flows, go to:

Explanation of Cash Flow Statement

Quiz for Cash Flow Statement
Crossword Puzzle for Cash Flow Statement
Additional Information and Resources
Because the material covered here is considered an introduction to this topic, many
complexities have been omitted. You should always consult with an accounting
professional for assistance with your own specific circumstances.