Financial ratio analysis is the process of calculating financial ratios by comparing financial data in a firm’s financial statements and analyzing them to the firm’s current financial position and its recent financial performance and to develop expectation about the firm’s future prospects.  Financial ratio analysis simplifies the process of financial comparison of a single firm and of different companies to one another.  Ratio analysis is essential to the application of financial statement analysis and is used to identify fundamental and structural relationships and trends.

Ratios are calculated on the basis of accounting information, which has such intrinsic limitations as historical cost, going concern value, stable monetary value, etc.  These limitations affect the quality of ratios, since the ratios cannot be more reliable than the accounting data used to calculate the ratios.

The Z-Score model evaluates a combination of financial ratios to predict the likelihood of future bankruptcy.  The model, developed by Edward Altman, uses multiple discriminant analysis (MDA) with a set of financial ratios to give a relative prediction of whether a firm will go bankrupt within one and two years in the future.

The Z-Score Formula
Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5
Where:
 X1 = Working Capital/Total assets
 X2 = Retained Earnings/Total assets
 X3 = EBIT/Total Assets
 X4 = Market Value of Equity/Book Value of Debt
 X5 = Sales/Total Assets

Different financial ratios are used to analyze different aspects of a firm’s financial position, performance and cash flows.  Deviations in the ratios are identified and examined to determine the reason for the deviations.  For ratio analysis to be meaningful, comparisons must be drawn across time and other companies in that industry.

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