Financial Statements Analysis
Interpretation of Financial Ratios
Financial statements analysis is the process of examining relationships among elements of the the company's "accounting statements" or financial statements (balance sheet, income statement, statement of cash flow and the statement of retained earnings) and making comparisons with relevant information.
Financial statements analysis is a valuable tool used by investors, creditors, financial analysts, owners, managers and others in their decision-making process.
The most common known types of financial statements analysis are:
- Horizontal Analysis: financial information are compared for two or more years for a single company;
- Vertical Analysis: each item on a single financial statement is calculated as a percentage of a total for a single company;
- Ratio Analysis: compare items on a single financial statement or examine the relationships between items on two financial statements.
Financial ratios analysis is the most common form of financial statements analysis. Financial ratios illustrate relationships between different aspects of a company's operations and provide relative measures of the firm's conditions and performance. Financial ratios may provide clues and symptoms of the financial condition and indications of potential problem areas.
Financial ratios generally hold no meaning unless they are compared against something else, like past performance, another company/competitor or industry average. Thus, the ratios of firms in different industries, which face different conditions are usually hard to compare.
Financial ratios can be an important tool for small business owners and managers to measure their progress toward reaching company goals, as well as toward competing with larger companies within an industry. In addition, tracking various ratios over time is a powerful way to identify trends. Ratio analysis, when performed regularly over time, can also give help small businesses recognize and adapt to trends affecting their operations.
Financial ratios are also used by bankers, investors, and business analysts to assess various attributes of a company's financial strength or operating results. This is another reason why business owners need to understand financial ratios because, very often, a business's ability to obtain financing or equity financing will depend on the company's financial ratios.
Financial ratios are categorized according to the financial aspect of the business which the ratio measures. Liquidity ratios examine the availability of company's cash to pay debt. Profitability ratios measure the company's use of its assets and control of its expenses to generate an acceptable rate of return. Leverage ratios examine the company's methods of financing and measure its ability to meet financial obligations. Efficiency ratios measure how quickly a firm converts non-cash assets to cash assets. Market ratios measure investor response to owning a company's stock and also the cost of issuing stock.
Despite all the positive uses of financial ratios, however, business managers and owners are still encouraged to know the limitations of ratios and approach financial ratio analysis with a degree of caution.