Financial statement analysis involves the examination of the relationships among financial statement numbers and the trends in those numbers over time. Relationships between financial statement amounts are financial ratios. A ratio is to standardize the measures on financial statements to enable comparison across time and companies of different sizes. Types of financial ratios: 1. Liquidity Ratios – the ability to meet the current period obligation, measures the ability to repay debt in the short run. Rule of thumb: the current ratio should be at least 2:1 (current ratio = current assets/ current liabilities, quick ratio = current assets – inventory/current liabilities, cash ratio = cash/current liabilities) 2. Profitability Ratios – return on sales shows the profit percentage for each dollar of sales, some income measures + some balance sheet accounts (return on sales = net income/sales) return on equity is the overall measure of performance of a company. Rule of thumb is that good companies generally have a return on equity between 15 and 25 percent (return on equity = net income/stockholders’ equity) 3. Activity (Efficiency) Ratios – to evaluate the efficiency and effectiveness in managing some business resource, some income statement accounts + some balance sheet accounts, the higher the turnover ratio, the more efficient the company is at using its assets to generate sales (asset turnover = sales/total assets, inventory turnover = COGS/avg. inventory – shows how many times during the year a company turns over its inventory during the year, A/R turnover = sales/avg. A/R – shows how man y times a company is collecting its average receivable balance, A/P = purchases/A/P – how many times a company is paying its average payable balance) 4. Leverage Ratios – to indicate the extent to which a company is using “debts” to finance the company, debt ratio represents