Wednesday, July 30, 2014
Essay on Financial Ratio Analysis
Overview of the Financial Ratio Analysis
Financial statement such as the balance sheet, income statement, and cash flow statement are significant tolls that various users utilize in making economic decisions. Among these users is the management who would want to know if the business is earning profit or losing money. For the publicly listed companies whose shares are traded in the stock market, figures on the financial reports are crucial for them in deciding whether to buy or sell shares of stocks. However, data included on the financial reports are raw, meaning, they only represents single data and do not reflect a comparative view of the overall performance of the company. Therefore, it would wise to perform a financial ratio analysis using the figures from different financial statement.
Financial ratio analysis is a decision-making tool that defines the relationship of all the financial statements and their components to one another. In performing ratio calculation, management and investor can take a glimpse on how each component affect the overall financial condition of the company. Research analyst and stock market advisors uses financial ratio to predict the strength and weakness of a company, thus, enabling them to forecast the possible trading direction of specific stocks. In addition, ratio analysis reflects how the company performs against the industry and its competitors.
However, to be effective, results of the ratio analysis must be comparative. It means that the results must be compared against the company’s previous results, against the ratio of the rival companies, or against the industry norm. The reason is that the main objective of conducting the ratio analysis is to evaluate the success of the company, and, on the other hand, identity the weaknesses that causes loses or decline.
Ratio are group into four, and the classification is based on the key factors that affects the overall performance of the company namely liquidity, profitability, solvency, and management efficiency.
Liquidity ratios measure the ability of an entity to pay current obligations and finance unexpected expenses. It shows the relationship between various balance sheet accounts to one another. Companies that have high liquidity ratios are more likely to have sufficient funds for its continuous operation. Current ratio, acid-test or quick ratio, and working capital ratio belongs to this group.
Profitability ratios on the other hand evaluate how the organization turns sales into net income. It is an income statement ratio because it defines how each component in the income statement affects the earning capacity of the company. Organization that is applying for finances such as bank loan would like to have a positive and better profitability ratio. Gross profit margin and net margin are some of the basic profitability ratios.
Next group is the solvency ratios, which indicates the capacity of the company to sustain normal operation on long-term basis. It reflects how the entity would likely to survive long-term risk and to pay long-term obligations including interest for any loans. Solvency ratio is significant for creditors and shareholders because most of the resulting figures would indicate if the company will able to pay long-term debts and if the company can pay dividends to their stockholders. Debt ratio, fixed asset-to-equity ratio, times interest earned and debt-to-asset ratio belongs to this category.
Last group is the efficiency ratio, which reflects the overall management efficiency in converting its assets and capital into sales and income. Efficiency ratio is both a balance sheet and income statement ratio because it uses different components of both the statement in evaluating management effectiveness. It also measures the success of various business strategies employed by the management such as the credit and collection policy, inventory maintenance standards, and payment to suppliers program. Included in this group is the inventory turnover, receivables turnover, total asset turnover, and fixed asset turnover.