# 20.6 Analysis

## Ratio Analysis – Overview

Ratio analysis occurs when relationships between selected financial data (presented in the numerator and denominator of the formula) provide key information about a company. Ratios from current year financial statements alone may not be as useful as when they are compared with benchmark ratios. Examples of benchmark ratios are a company’s own historical ratio trends, future ratio targets set by management as part of its strategic plan, industry sector ratios from the sector that the company operates in, or ratios from competitors, if obtainable.

Care must be taken when interpreting ratios because companies within an industry sector may use different accounting policies, which affect the comparison of ratios. In the end, ratios are based on a company’s current and past performance and are merely indicators. Further investigation is needed to gather more business intelligence about the reasons why certain variances in the ratios occur.

## Free Cash Flow (FCF) Analysis

Another way to assess a company’s cash flow liquidity is the free cash flow. Free cash flow is the cash flow remaining from operating activities after deducting cash spent on capital expenditures, such as purchasing property, plant and equipment. Some companies also deduct cash paid dividends. The remaining cash flow represents cash available to the company to do other things such as expand its operations, pay off long-term debt or reduce the number of outstanding shares. Below is the calculation using the data from Watson Ltd.’s statement of cash flows.

Watson Ltd.
Free Cash Flow
December 31, 2020
Cash flow provided by operating activities $(101,660) Less capital expenditures 0 Dividends (42,590) Free cash flow$(144,250)

It is no surprise that Watson Ltd. has no free cash flow and no financial flexibility, since its operating activities are in a negative position. Watson Ltd. met its current year dividend cash requirements by selling more common shares to raise additional cash, thus diluting the shareholders’ investment position. When calculating the free cash flow, the capital expenditures amount should be limited to those that relate to daily operations that are intended to sustain ongoing operations, such as PPE expenditures. Meaning, capital expenditures purchased as investments are usually excluded from the free cash flow analysis.