Financial Ratio Analysis - Your Key to informed Business Decisions

Financial analysis is performed to determine the relative strength and weaknesses of a firm. Investors need this information to estimate both future cash flow from the firm and the riskiness of those cash flows. Financial Managers need the information provided by analysis both to evaluate the firm’s past performance and to map future plans. The financial analysis concentrates on financial statement analysis which highlights the key aspects of a firm’s operation. 

Financial statement analysis involves a study of the relationships between income statement and balance sheet accounts, how these relationships change over time (or trend analysis), and how a particular firm compares with other firms in its industry (comparative ratio analysis). Although financial analysis has limitations, when used with care and judgment, it can provide some beneficial insight into the operation of a firm.

A firm’s annual report to shareholders presents two important types of information. The first is a verbal statement of the company’s recent operations and expectations for the coming year. The second is a set of quantitative financial statements which report what actually happened to the firm’s financial position, earnings, and dividends over the past few years. Financial statements are used to help predict the firm’s future earnings and dividends. From an investor’s standpoint, predicting the future is what financial statements analysis is all about. From management’s standpoint, financial statements analysis is useful both as a way to anticipate future conditions and, more importantly, as a starting point for planning actions that will influence the future course of events. Analyzing the firm’s ratio is the first step in financial analysis. Ratios are designed to show relationships between financial statement accounts within firms and between firms. 

We can figure out the following major group of ratios:  

• Liquidity ratios are used to measure a firm’s ability to meet its current obligations as they come due.  
• Asset management ratios measure how effectively a firm manages its asset and whether or not the level of those assets is correctly related to the level of operations measured by sales.  
• Debt management ratios measure the extent to which a firm uses debt financing or financial leverage and the degree of safety afforded to creditors.  
• Profitability ratios show the combined effects of liquidity, asset management, and debt management on operating results.  
• Market value ratios relate the firm’s stock price to its earnings and book value per share and thus give management an indication of what investors think of the company’s past performance and future prospects. 

It is important to analyze trends in ratios as well as their absolute levels. Trend analysis can provide clues as to whether the firm’s financial situation is improving or deteriorating in relation to past performance. 

A modified Du Pont chart shows the relationships among return on investment, asset turnover, net profit margin, and leverage. 

Comparative ratio analysis is useful in comparing a firm’s ratios with those of other firms in the same industry. Sources for such ratios include Dun & Bradstreet, Robert Morris Associates, the U.S. Commerce Department, and trade associations.

It is clear that there will be some inherent problems and limitations to ratio analysis that necessitate care and judgment. 

Conclusion:

Financial statements contain lots of information summarized in figures. Viewed on the surface, they do not provide enough information about the viability of the reporting entity. Thus, they need to be analyzed by means of financial ratios to unravel the truth hidden in them and enhance decision-making. Ratio analysis helps to reveal, compare and interpret salient features of financial statements. When applied to a set of financial statements, financial ratios highlight significant aspects of a business's financial position and operational results requiring further investigation. They help to identify the strengths and weaknesses of a business. In fact, ratio analysis helps to evaluate the past performance, the present condition, and the future prospects of a business. It enables us to ask the right questions about a business and paves the way to find the right answers. Such analysis, therefore, aids planning, control, forecasting, and decision-making.

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