Ratio analysis is a useful tool for assessing a company's performance since it enables multiple perspectives on its financial situation. Financial ratios can be used as a tool to assess a company's liquidity, financial stability, activity, or profitability depending on the needs of an analyst (these are the main existing ratio categories). Applying ratio analysis to a company's financial records can serve as a foundation for drawing various inferences about the health of the enterprise as well as for forecasting potential development patterns. It is beneficial to a wide range of users, including business owners looking to increase corporate efficiency and current and potential investors using ratio analysis as a risk management tool.
Indicators of the company's ability to fulfill its present obligations are provided by liquidity ratios. The company's current assets and current liabilities are the primary subjects of the liquidity ratio analysis. The capacity to repay current liabilities is a crucial sign of a company's financial viability. Cash ratio, quick ratio, current ratio, and others are the primary ratios that fall under this category.
Debt ratio analysis is being used to gauge a company's financial viability. It reveals a company's capacity to sustain its debt over the long term. Greater debt typically entails a higher chance of bankruptcy, therefore it's critical to know whether the company has adequate financial resources to satisfy its long-term obligations. The debt ratio, times interest earned, debt to equity ratio, etc. are some of the key ratios in this category.
Activity ratios gauge how effectively the organization uses its resources. It reveals the effectiveness of the company's asset management system. The activity ratios will show positive trends if the company uses its inventories, fixed assets, and accounts receivable in an efficient enough manner. Total asset turnover, accounts receivable turnover, cash conversion cycle, and other ratios are included in this group.
A collection of profitability ratios is one of the most significant indicators of a company's performance. These ratios assess the company's capacity to generate profits, which is its primary objective. The two most prevalent divisions of profitability ratios are margins (which demonstrate the company's capacity to convert sales revenue into profits) and returns (measuring the ability of the company to generate returns for the stockholders). Net profit margin, return on assets, and other metrics are important ratios in this group.
The company's financial primary statements contain all the information required for the computation of the aforementioned ratios (balance sheet, income statement, etc.). Even if a collection of the same ratios produced for several time periods lacks sufficient data for a thorough study, it will typically still show a general upward or downward trend in the firm's development. It's important to compare all the calculated ratios with the major rivals and with industry averages in order to prevent drawing incorrect conclusions.
The structure and dynamics of a company's assets, as well as its sources of funding and financial outcomes, can be understood through vertical and horizontal analysis. Vertical analysis demonstrates the relative importance of various components and sheds light on their balance. As an illustration, the high percentage of trade receivables indicates that customers are diverting capital away from the operational process. This may result in an increase in the price of attracting more financial resources. Understanding the equity and liabilities vertically helps to determine how well creditors are protected. Given a substantial share of equity, one can be sure that lenders of financial resources will get their money back in the event of insolvency. Vertical examination of financial data reveals the significance of various revenues and expenses for the business as well as their function in the process of making a profit.
A horizontal analysis shows how a given element's value changed during the course of the investigation. Year-to-year change analysis, which is a component of the horizontal analysis, aids in forecasting future performance based on historical financial data. A financial risk analysis can evaluate the company's financial risks by taking into account industry and macroeconomic developments. For instance, a reduction in working capital from year to year can result in a loss of liquidity. If a corporation has a persistent trend of losing equity, it may become insolvent.
It's significant to note that different industries experience different financial situations. For instance, the global market for automation software is expanding, yet gas extraction businesses are experiencing difficulties as a result of the cheap price of fuel. It is necessary to compare it to its main rivals for this reason. Since businesses operate under similar circumstances, understanding management effectiveness is beneficial. Greater financial effectiveness results from better performance on the same market. Analyses might also compare the researched company's metrics to industry averages.
The results of each approach should be reflected in the financial analysis of the company's overall findings. An analysis can highlight the company's financial strengths and problems and offer insight into its future possibilities. One can respond to the following queries depending on the objective of the financial statement analysis:
1. How efficient is a business?
2. How solid is its position right now?
3. What are the net assets worth?
4. How well are creditors safeguarded?
5. Are there any risks to the business's long-term financial viability?
6. Are there any modifications that will affect performance going forward?