Financial accounting

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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.
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.


Illustration 1   

Financial ratio classifications

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.


Illustration 2  

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.

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