Business finance plays an important role in financial decision making by offering valuable information on the condition and performance of a firm to different stakeholders such as investors, creditors, and managers.
Ratio analysis acts as a basic step in achieving this understanding. This method involves undertaking an analysis of the several financial ratios that are obtained from the financial statements of a firm with an objective of affirming its performance, stability and profitability. Those analysing the ratio can effectively make decisions concerning any firm on the basis of these ratios. The training courses in Accounting from the British Academy for Training and Development provide information regarding financial analysis and management accounting.
“Ratio analysis is the tool which focuses on assessing the financial worth of an organisation based on figures drawn from the income statement and balance sheet.”
This method involves making different ratios that give an indication of the liquidity position, solvency position as well as the profitability and efficiency of a given company. These ratios help in examining the general efficiency of a company handling its assets and liabilities.
The importance of ratio analysis lies in its ability to identify trends as well as show where a company is most effective or has areas that need attention. It provides insights that are critical for:
Investors: To determine profitability and financial solvency in order to estimate possible revenue to be leveraged from the company’s resources.
Creditors: As a tool for assessing the capacity of repaying debts in a company.
Managers: In order to reach strategic decisions and gain increased financial performance.
Various types of financial ratio analysis are aimed at the different aspects of analysis of the company’s financial results. The main categories include:
These ratios show how well a business organisation is placed to meet its short-term liabilities with existing resources. Liquidity ratio is usually measured as the current ratio and the quick ratio. If the ratio is high, it ideally means that the company can be in a position to meet its short-term debts.
Solvency ratios are designed to measure the company’s capability of paying out its long-term liabilities. Such ratios as debt equity and interest coverage ratios which tell about more managerial safety and long-term stability of the firm.
These ratios indicate a company’s efficiency in the achievement of profit from operations. Among the most popular measures of profitability are the net profit margin, return on assets and return on equity. Thus, the relative magnitude of the profitability ratios reflects the efficiency of management and the feasibility of the observed business model.
Efficiency ratios reflect how efficiently the total assets and liabilities have been utilised to derive business revenues. The intensity at which the inventory is turned over, by the inventory turnover ratio and efficiency in collecting receivables through the accounts receivable turnover ratio is shown.
These measures measure how well a firm is placed financially, for instance on matters to do with the payment of debts. The interest coverage ratio gives investors and analysts a look at how well the company can meet its interest costs on outstanding debts.
Market prospect ratios indicate how the current market position of an enterprise will look like in the future in terms of financial performance. Measures such as the P/E ratio that is price-to-earnings and dividend yield allow clients to decide if a company’s equities are over or underpriced.
Ratio analysis is popular in finance and is the most widely used tool for financial analysis and control. Businesspeople use it to assess the financial health of a company, make comparisons of industry, market analysis, tax savings, and more. They are used for evaluation of the financial structure, revelation of a company's advantages and disadvantages and identification of the areas requiring enhancement. It is used as a benchmark where firms are able to compare their financial performance ratios with those in the industry.
While ratio analysis is a valuable tool for assessing a company’s financial health, it has some limitations:
Ratios are founded on information extracted from financial statements, which may not necessarily reflect the current position or future conditions. Market conditions that occur suddenly or other factors that can make data and information become outdated can lead to a decline in its efficiency for prediction of results.
While working with financial ratios, only numerical data is taken into consideration and no qualitative characteristics such as quality of the management, the company’s reputation, or morale of the employees are taken into consideration, though they are equally important for evaluating the performance of the company.
The selection of appropriate accounting policies (for example, depreciation policies or inventory valuation policies) may change ratios and thus analysis of trends and performances may be distorted. This is because companies adopting different standards such as GAAP or IFRS may produce dissimilar financial images thus leading to inconsistency of ratio analysis.
Ratio analysis does not allow the consideration of external factors such as market conditions, economic conditions or changes in regulations or laws. These factors remain outside the business organisation but are important in determining its performance and need to feature in an evaluation.
However, the ratios can show the past and the present reality of the company’s financial health; they do not give clear information about the future. Forecasting is usually done ad hoc and in combination with other analytical tools, such as cash flow, or trend analysis.
To evaluate the performance of the company, there are multiple ratios that are taken into consideration. A highly liquid firm with little or no debts and high profitability ratios is regarded as financially healthy. Also, the analysis of performance ratios and financial analysis performance over a period enables one to notice the trends and possible areas that require some attention. Unlike a single ratio, a combination of varying sets of ratios gives a decent insight into the company’s financial health.
Financial analysis ratios are used by investors as tools to assess the performance, profitability and prospect of any company. Ratios allow investors to make some form of comparison between different firms in the same line of business. Understanding why investors use financial ratio analysis, it will be easier to appreciate the usefulness of ratio analysis when it comes to arriving at the right investment decisions. Ratios such as P/E and ROE are used in determining the returns on investment and risk level.
Some of the most commonly used ratios for financial analysis include:
Net Profit Margin: This shows gross profit after deducting all the expenses of the business.
Debt-to-Equity Ratio: Discusses the relative proportion of the amounts raised from debts and equities.
Current Ratio: Analyses the short-term working capital position.
Return on Equity (ROE): Illustrates the amount of return derived on shareholders’ equity.
In conclusion,
Ratio analysis can be beneficial when evaluating various aspects of the company’s financial situation and results. Financial ratios like Liquidity, profitability, efficiency and market prospect ratios – when used to their optimality – enable the stakeholders to get a clear insight into a company’s financial health. Regardless, if it is for the assessment of investment or for releasing better control over organisational assets, ratio analysis continues to have a place in financial decision-making.