Financial Ratio Analysis

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Performance measures are calculated values that allow conclusions to be drawn from data. Performance measures drawn from financial statements can be used to answer such questions as:

1. Is the firm able to meet its short-term financial obligations?

2. Are sufficient profits being generated from the firm's assets?

3. How dependent is the firm on its creditors?

Financial ratios are one kind of performance measure that can answer these questions. They give an analyst a framework for asking questions about the firm's liquidity, asset management, leverage, and profitability. Financial ratios are ratios between key amounts taken from the financial statements of the firm. While financial ratios are simple to compute, they do require some skill to interpret, and they may be used for different purposes. For example, internal management may be concerned with the firm's ability to pa}- its current liabilities or the effect of long-term borrowing for a plant expansion. An external investor may be interested in past and current earnings to judge the wisdom of investing in the firm's stock. A bank will assess the riskiness of lending money to a firm before extending credit.

To properly interpret financial ratios, analysts commonly make comparisons with ratios computed for the same company from previous financial statements (a trend analysis) and with industry standard ratios. This is referred to as financial ratio analysis.

Industry standards can be obtained from various commercial and government websites and publications. In Canada, Statistics Canada (www.statscan.ca) publishes Financial and

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