Financial analysis is one of the many tools useful in valuation because it helps investors gauge returns and risks. Investors have many tools available in the analysis of financial information. These tools include financial ratio analysis and quantitative analysis. The former is the subject of this appendix.
When assessing a firm's operating performance, investors are concerned with whether management is applying corporate assets in an efficient and profitable manner. When investors assess a firm's financial condition, a concern is whether the corporation is able to meet its financial obligations. Investors can utilize financial ratios to evaluate five aspects of operating performance and financial condition: (1) return on investment, (2) liquidity, (3) profitability, (4) activity, and (5) financial leverage. There are several ratios reflecting each of the five aspects of a firm's operating performance and financial condition and we discuss them below.1
Return-on-investment ratios compare measures of benefits, such as earnings or net income, with measures of investment. For example, an investor evaluating how well the firm uses its assets in its operations could calculate the return on assets—sometimes called the basic earning power ratio—as the ratio of earnings before interest and taxes (EBIT) (also known as operating earnings) to total assets:
Another return-on-assets ratio uses net income—operating earnings ...