Financial ratio analysis is important to a business’s success. A financial ratio analysis is an indicator of a company’s financial performance. It helps a business compare company financials with previous periods and also allows a business to contrast its financials to similar companies. A financial ratio can provide a clear image of a company’s state and identify trends that are emerging.
Use of ratios in analyzing financial statements
Ratio analysis is a form of financial analysis that utilizes one or more pieces of information obtained from a company’s financial statements to help determine a business’s strengths and problem areas (ITS Tutorial School , 2005).
Investors, creditors, and administration of a company can use financial ratio analysis to assess a company. Furthermore, financial ratio analysis assists in industry comparisons and analyzing trends of a company. Industry comparisons ratios contrast a company against comparable businesses or with industry averages to evaluate the company’s performance to competitors (ITS Tutorial School , 2005).
Trend analysis is a method of evaluating an organization’s past, current, and anticipated financial position (ITS Tutorial School , 2005).
This helps determine whether a business’s financial state is improving or declining over a period of time.
Financial analysis of a balance sheet
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A company’s balance sheet shows how a business is financed and the value their assets. The financial analysis of a balance sheet focuses on a business’s internal structure and distribution of company resources (Droms & Wright, 2010).
It also reveals ways a business invests assets, allocates resources of working capital investments such as, cash, accounts receivable, and inventory, and indicates the liabilities and equity side of a business (Droms & Wright, 2010).
Therefore, a company is able to understand and modify its financial situation. For example, a company that is using a lot of debt to finance the company could start reducing their amount of debt by looking at others alternatives, which would help lower the company’s financial risk (Shadunsky, 2012).
Financial analysis of an income statement
The income statement displays a business’s revenue and expenses over a specified amount of time. Analysis of an income statement shows the amount of sales or income engrossed by different costs and expenses (Droms & Wright, 2010).
The financial analysis of income statement can help an organization understand their margins and costs compared those of competitors (Shadunsky, 2012).
Comparing costs with those of competitors will allow a company to focus on costs and make reasonable changes to the price of a product, if needed, which will ultimately help generate more income.
Financial analysis of a cash flow statement
A cash flow statement demonstrates the movement of cash within a company during a specific year. The cash flow statement provides important information about a company’s total resources and expenditures of cash (Droms & Wright, 2010).
Performing an analysis on the net income of cash flow will help a company gain an idea of their effectiveness in converting accounting income into cash (Shadunsky, 2012).
A company can use the information gathered from the analyses to focus on understanding their cash flow and how it affects the company’s bottom line, in terms of net income (Shadunsky, 2012).
This information can be used to identify problem areas in the cash flow statement. As a result, a company could make changes needed to alleviate any issues that have been found.
Importance of financial ratios
Financial ratios are a significant aspect of understanding a business’s financial stance. Ratios are helpful in gaining an understanding of a company’s financial situation for investors, creditors, and management (Droms & Wright, 2010).
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Ratio analysis can be used to evaluate a company’s financial position, which is helpful in making business decisions (Droms & Wright, 2010).
Ratios can be used to estimate the efficacy of a company’s operations and management (Droms & Wright, 2010).
This will assist an organization in arbitrating the business’s ability to effectively earn revenue and use assets.
Ratios can be utilized in finding weaknesses in a company’s operations. Once the weaknesses are identified, management can take action to overcome the problem areas. Ratios are also a great way to analyze a company’s past financial performance and can determine future financial performance trends. Consequently, ratios aid in creating a company’s future endeavors. Finally, ratio analysis helps a company understand their performance trends and contrast their performance to similar companies.
Benefits and pitfalls for shareholders, bankers, and small companies
Financial ratio analysis is also useful tool for a shareholder, banker, or a small company. It helps interested parties determine whether a particular company would be a great investment. Ratio analysis provides important information regarding several different factors of a business. The first being a company’s liquidity which help financiers determine an organization’s liquidity or ability to meet short-term debt responsibilities (Droms & Wright, 2010).
Secondly, asset turnover can be measured to understand how efficient a company is in using assets (Droms & Wright, 2010).
Thirdly, individuals can evaluate a business’s leverage by comparing company debt to net worth (Droms & Wright, 2010).
Next, investors can identify a company’s operating performance and profitability, which will help them gain insight about how effective a company is using available resources to increase profitability and shareholder’s value (Droms & Wright, 2010).
Lastly, a shareholder can check the valuation of a company, or determine whether a company’s stock price is appealing.
There also are some pitfalls for shareholders, bankers, and small companies when using ratio analysis. The financial statement analysis may not be known or understood by shareholders. There is also a possibility of inaccuracy, due to manipulated numbers in the data provided (Accounting For Management, 2012).
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... and learn how to use them. Financial ratio analysis is an excellent tool for companies to evaluate their financial health in order to identify feebleness ... while users are more interested about present and upcoming information (“Accounting for management”, 2011). Basically, they give a clue or sign of ...
If the data is manipulated, it does not reveal the true state of the company (Accounting For Management, 2012).
Another problem is the use of quantitative financial analysis sometimes results in different outcomes from the same information and a variety of data could be found for one company (Accounting For Management, 2012).
Shareholders use a company’s profitability when deciding whether a company is a good investment (Droms & Wright, 2010).
Investors are only concerned with a company’s present value and anticipated profits, but ratios are constructed from financial statements that show the past performance of a company (Accounting For Management, 2012).
It could be difficult for a shareholder to make sensible forecasts about a company’s future trends (Accounting For Management, 2012).
Small companies can use ratio analysis for evidence about the financial condition of their company or contrast itself against comparable businesses. Since there are some differences in accounting practices in companies, it could be difficult to compare financial information between companies (Accounting For Management, 2012).
Companies should understand problems with comparing business financial data before making inferences (Accounting For Management, 2012).
Bank loan officers are more concerned with a company’s short-term liquidity and the collateral value of liquid assets when determing business risk (Droms & Wright, 2010).
Organizations can incorrectly report items on the financial documents, mistakenly or purposely. The data provided to the bank may be unreliable, if bad data is used; ratios that have been constructed with this corrupted data are erroneous (Accounting For Management, 2012).
The Essay on Managerial Accounting Management Information Accountants
Simply stated, the financial accountant is the number cruncher while the managerial accountant is the analyzer. However, it is not that simple. Most experts are fairly consistent with their definitions of what the financial accounting entails, however, defining managerial accounting appears to be opinion dependent. As the population of the occupation grows so does the defined responsibilities ...
Two key ratios
All ratios are beneficial to a company in some way, but if I had to choose two key ratios, I would select current liquidity ratio and company’s profit margin. The current liquidity ratio uses a company’s current assets and divides that amount by the company’s current liabilities (Droms & Wright, 2010).
The current liquidity ratio demonstrates a company’s ability to meet current liabilities (Droms & Wright, 2010).
The formula for the profit margin is net income divided by sales (Droms & Wright, 2010).
This ratio measures the percentage of profits earned for every dollar of sales.
Information overload
Financial statements provide well-summarized financial information about a company. The detailed information could lead to information overload. The issue is having an overwhelming amount of data can cause important information to become unnoticed because the amount of insignificant information in the statements. Consumers may also become frustrated with the amount of data.
Conclusion
Financial ratios measure a company’s condition and performance. When ratios analysis is used correctly, important information about underlying business issues or successes can be identified. A company can use results from ratio to make adjustments that will ultimately benefit the organization.
References
Accounting For Management. (2012).
Limitations of Financial Statement Analysis. Retrieved September 25, 2012, from http://www.accounting4management.com: http://www.accounting4management.com/limitations_of_financial_statement_analysis.htm#G8ihQeifDBs7KxcY.99 Droms, W., & Wright, J. (2010).
Finance and Accounting for Nonfinancial Managers (6th edition).
Cambridge, Massachusetts: Perseus Books Group. ITS Tutorial School . (2005).
Accounting, Business Studies and Economics Dictionary . Retrieved September 22, 2012, from http://www.tuition.com.hk/: http://www.tuition.com.hk/dictionary/f.htm#Financial_ratio Shadunsky, A. (2012).
What Kind of Analysis Can I Do for My Financial Statements? . Retrieved September 23, 2012, from http://www.ehow.com/: http://www.ehow.com/info_12016805_kind-analysis-can-financial-statements.html
The Essay on The Use Of Financial Accounting Information In Making Informed
Abstract This assignment will address the necessary steps involved with evaluating the use of financial accounting information in making informed and ethical business decisions using comparative analysis and financial ratios. Managerial Analysis – Assignment 2 In order for any entity (the company, its managers, investors, debt holders, etc.) to understand the valuation of a company, one must ...
