Financial Ratio Analysis
Essay Preview: Financial Ratio Analysis
Report this essay
Financial ratio analysis is the calculation and comparison of ratios which are derived from the information in a companys financial statements. The level and historical trends of these ratios can be used to make inferences about a companys financial condition, its operations and attractiveness as an investment.
Financial ratios are calculated from one or more pieces of information from a companys financial statements. For example, the “gross margin” is the gross profit from operations divided by the total sales or revenues of a company, expressed in percentage terms. In isolation, a financial ratio is a useless piece of information. In context, however, a financial ratio can give a financial analyst an excellent picture of a companys situation and the trends that are developing.
A ratio gains utility by comparison to other data and standards. Taking our example, a gross profit margin for a company of 25% is meaningless by itself. If we know that this companys competitors have profit margins of 10%, we know that it is more profitable than its industry peers which is quite favourable. If we also know that the historical trend is upwards, for example has been increasing steadily for the last few years, this would also be a favourable sign that management is implementing effective business policies and strategies.
Financial ratio analysis groups the ratios into categories which tell us about different facets of a companys finances and operations. An overview of some of the categories of ratios is given below.
Leverage Ratios which show the extent that debt is used in a companys capital structure.
Liquidity Ratios which give a picture of a companys short term financial situation or solvency.
Operational Ratios which use turnover measures to show how efficient a company is in its operations and use of assets.
Profitability Ratios which use margin analysis and show the return on sales and capital employed.
Solvency Ratios which give a picture of a companys ability to generate cashflow and pay it financial obligations.
It is imperative to note the importance of the proper context for ratio analysis. Like computer programming, financial ratio is governed by