Financial Statement and Ratio Analysis
Financial ratios are mathematical comparisons of financial statements or categories. These relationships between the financial statement accounts help investors, creditors, and internal company management understand how well a business is performing and of areas needing improvement.
Values used in calculating financial ratios are taken from the balance sheet, income statement, statement of cash flows or (sometimes) the statement of changes in equity.
Ratios are easy to understand and simple to compute. Financial analysts use financial ratios to compare the strengths and weaknesses in various companies. Ratios allow us to compare companies across industries, big and small, to identify their strengths and weaknesses.
They are used for the following comparisons:
- between different time periods for one company
- between companies
- between industries
- between a single company and its industry average
Ratios are not useful unless they are benchmarked against something else, like past performance or another company.
Financial ratios are categorized according to the financial aspect of the business which the ratio measures.
Profitability ratios measure the company’s use of its assets and control of its expenses to generate an acceptable rate of return
Liquidity ratios measure the availability of cash to pay debt.
Efficiency Ratios (Activity ratios)
Activity ratios measure the effectiveness of the firm’s use of resources.
Debt ratios (leveraging ratios)
Debt ratios quantify the firm’s ability to repay long-term debt. Debt ratios measure financial leverage.