Definition
Financial ratio analysis is the result of dividing one financial statement item by another is financial item. Ratios help financial analysts to interpret financial statements by focusing on specific relations.
In more simple words a ratio is nothing more than a simple division of two numbers. Often numbers by themselves do not convey anything until they are related. It needs a contextual reference in addition to the assurance that the numbers being used are reliable.
Financial statements by themselves reveal only partial information about the performance, liquidity, gearing etc. of an entity. Financial ratio analysis allows users to focus on various areas of business management to compare results against industry averages and to gauge the financial health of an investment prospect. Ratios can be the keys to success in many arenas where identification of norms, benchmarks, internal eccentricities or long term trend area critical.
Ratio are helpful in interpreting financial statements, identifying problem areas, and making future plans. However, a ratio by itself is meaningless. It is only useful when it provides a benchmark for making comparisons for making comparison to prior year’s ratios, ratios of other firms, and to projections made in preparing plans for the firm.
How to Use the Ratios
In order to know how to use a ratio, let’s check how not to use one. Look at the example and understand how a ratio by itself can be misleading. Take example of a fast growing software company for which receivables as percentage of sales increased from 25% last year to 50% this year. Is it bad? Many accountants would immediately decree that the company’s working capital management is poor. Debtors are high, the company will have cash problems, interest on working capital will go up.
Types of Ratios
Financial ratios may be classified according to the motive to use the ratio i.e.
- To analyze the company profitability
- To analyze the company liquidity
- To analyze whether company meets it tax liability
- To analyze can company repay its debts
- To analyze whether using its resources efficiently
Ratios can by classified into
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Liquidity ratios
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These help us understand whether we can meet our obligations over the short-term. Higher liquidity levels indicate the we can easily meet our current obligations.
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Profitability ratios
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These ratios measure the level of earnings in comparison to a base, such as assets, sales or capital. We can do a company probability analysis by examining the revenue it earns.
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Activity ratios
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Analyzing efficiency of assets usage to generate revenue
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Investors ratios
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To analyze returns of company investors
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Gearing Ratios
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To analyze company stability and its ability to repay its long-term debt
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Cash Flow Ratios
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To analyze cash flow statement
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Financial ratio analysis of balance sheet and income statement make it possible to draw inferences, make comparison and track long term results.