FINANCIAL ACCOUNTING Topic 9: Define and Compute Liquidity, Solvency, and Profitability Ratios
Reference: Kimmel, Paul. D., Weygandt, Jerry. J. & Kieso, Donald. E. (2006). Financial Accounting: Tools for Business Decision Making (4th ed.). Hoboken, NJ: John Wiley & Sons. Used with permission from the publisher.
Introduction Ratio analysis expresses the relationship among selected items of financial statement data. A ratio expresses the mathematical relationship between one quantity and another. The relationship is expressed in terms of either a percentage, a rate, or a simple proportion.
To illustrate, Best Buy has current assets of $5,724 million and current liabilities of $4,501 million. We can determine a relationship between these accounts by dividing current assets by current liabilities, to get 1.27. The alternative means of expression are:
Current assets are 127% of current liabilities.
Current assets are 1.27 times as great as current liabilities.
The relationship of current assets to current liabilities is 1.27:1.
For analysis of the primary financial statements, we classify ratios as follows.
Ratios can provide clues to underlying conditions that may not be apparent from examination of the individual items on the financial statements. However, a single ratio by itself is not very meaningful. Accordingly, in this and the following chapters we will use various comparisons to shed light on company performance:
Intracompany comparisons covering two years for the same company.
Industry-average comparisons based on average ratios for particular industries.
Intercompany comparisons based on comparisons with a competitor in the same industry.
Best Buy Company generates profits for its shareholders by selling electronics goods. The income statement reports how successful it is at generating a profit from its sales. The income statement reports the amount earned during the period (revenues) and the costs incurred during the period (expenses). Illustration 2 shows a simplified income statement for Best Buy.
Best Buy's income statement
From this income statement we can see that Best Buy's sales and net income both increased during the year. Net income increased from $622,000,000 to $800,000,000. Best Buy's primary competitor is Circuit City. Circuit City reported a net loss of $787,000 for the year ended February 29, 2004.
To evaluate the profitability of Best Buy, we will use ratio analysis. Profitability ratios measure the operating success of a company for a given period of time.