What is financial ratio analysis?

Financial ratio analysis uses data found in financial documents like the balance sheet and cash flow statement to evaluate a company’s financial strength. These financial ratios help business owners and average investors assess profitability, solvency, efficiency, coverage, market value, and more.

Types of Financial Ratios

There are six categories of financial ratios that business managers typically use in their analysis. Within these six categories, there are many financial ratios that assist business managers and external investors in analyzing the financial condition of a company.

Liquidity Ratios

Liquidity ratios answer the question of whether a particular company can meet its current obligations with its current assets. There are three main liquidity ratios that business managers look at:

Efficiency Ratios

Efficiency ratios, also known as asset management ratios or activity ratios, are used to determine how effectively a business is utilizing its assets to generate sales and maximize profit or shareholder wealth. They measure the efficiency of a company’s operations internally and over the short term. The four most commonly used efficiency ratios calculated from balance sheet and income statement information are:

Liquidity Ratios

Liquidity ratios allow the analyst to assess the company’s ability to cover its financial obligations and meet associated costs. These obligations include interest expenses, rent payments, and sometimes dividend payments. These ratios work alongside liquidity ratios to give the financial manager a complete picture of the company’s debt situation. There are two main liquidity ratios:

Profitability Ratios

Profitability ratios are the summarized ratios for the business. When calculating profitability ratios, the effects of liquidity management, asset management, and debt management on the company are aggregated. The four most common and significant profitability ratios are:

Market Value Ratios

Market value ratios are typically calculated for publicly listed companies and are not widely used for very small companies. There are three main market value ratios:

How Does Financial Ratio Analysis Work?

Financial ratio analysis is used to derive information from a company’s financial data that cannot simply be evaluated by inspecting the data itself. Ratios are usually calculated for a specific timeframe such as a quarter or a year.

Interpreting Financial Ratio Analysis

A single ratio calculation does not provide much information on its own. Financial ratios are only valuable if there is a benchmark for comparison. Each ratio should be compared to prior periods of the company’s data. Ratios can also be compared using data from other companies in the industry.

Who Uses Financial Ratio Analysis?

Several stakeholders may need to use financial ratio analysis:

• Financial Managers: Financial managers need the information provided by financial ratio analysis on the performance of various financial functions within the company. Ratio analysis is a valuable and powerful tool for financial analysis.
• Competitors: Other companies in the same industry find information about other companies in their industry important for their competitive strategy.
• Investors: Current and potential investors (whether publicly traded or funded through venture capital) need the financial information obtained from ratio analysis to determine whether they want to invest in the company.

Frequently Asked Questions (FAQs)

What are the 5 main financial ratios?

Five of the most important financial ratios for new investors include the price-to-earnings ratio, current ratio, return on capital, inventory turnover ratio, and operating margin.

Why does financial ratio analysis matter?

Financial ratio analysis quickly provides a snapshot of a company’s financial health. Instead of having to look at raw revenue and expense data, business owners and potential investors can simply glance at financial ratios that summarize the information they want to understand.

Source: https://www.thebalancemoney.com/what-is-financial-ratio-analysis-393186