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
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). Ratio analysis can be used to evaluate a company’s financial position, which is helpful in making business...