Financial Statement Analysis

Chapter 4Analysis of Financial Statements Using Causal Ratios

Learning objectives

• Identify which ratios are causal and which are not.
• Calculate each causal ratio.
• Recognize how each ratio affects profits, net worth, working capital, and debt.

Introduction

The purpose of this section is to provide a procedure that will tell the user why the firm’s financial statements are changing. The procedure to be used is the analysis of a set of financial ratios. These ratios focus on why the statements are changing and not just on the change itself. The chapter covers the ratios and shows why they are causal in nature. The ratios covered are fixed assets to net worth, the collection period, net sales to inventory, net sales to net worth, the profit margin, and miscellaneous assets to net worth.

Causal ratios

Ratio analysis helps to set limits on the firm’s liquidity, capital structure, and profitability.

What happens when you do the ratio analysis of any firm, XYZ?

The analyst will very likely find XYZ company deficient in several areas, but above average in others. What can we conclude about XYZ? The causal ratios help to provide an answer. By viewing the effect of these six ratios on the firm, we will understand why the firm is in the situation (good or bad) that it is.

An analogy may help at this point. A boy is running down the street. He steps into a pothole and falls. Stepping in the pothole caused him to fall. The fall did not cause him to step in the pothole.

Ratio analysis ...