Financial ratio analysis is a powerful management tool. It can uncover waste, inefficiency, and inattention within a company’s financial reporting process. It can also tell managers how to make their company’s financial data more understandable and accessible to the public. Even the accounting services providers use it to help make critical business decisions for their clients. This article will review what financial ratio analysis is, its purpose, and its types, along with examples of financial ratio analysis used in practice.
What is Financial Ratio Analysis?
Financial ratio analysis is a tool that helps an investor identify areas of a company’s financial reporting that may require additional attention. When a company reports financial results, investors use ratios and analytics to compare the performance of various business segments and identify areas where extra attention might be warranted. Investors may also conduct their version of financial ratio analysis to uncover potential areas of inefficiency within the company. Some companies also call this type of analysis “fundamental analysis” to draw on more profound insights into the company’s long-term viability.
Financial ratio analysis is a combination of measurement and analysis. Business accounting services use financial statements and reports to conduct ratio analysis and futuristic decisions based on them.
Why Use Financial Ratio Analysis?
A business’s financial ratio analysis is used to uncover inefficiencies and waste within companies. Their goal is to improve the company’s financial reporting process by identifying areas where additional effort is warranted to bring the numbers into line with accounting rules. This may include setting aside funds to correct the underlying issues, identifying which accounting methods might be at fault, and following up with regulatory filings to ensure the numbers are correct.
Types of Financial Ratio Analysis
There are many types of financial ratio analysis, but the most common ones tend to be grouped under the following headings:
- Liquidity Ratios
- Solvency Ratios
- Profitability Ratios
- Efficiency Ratios
- Coverage Ratios
- Market Prospect Ratios
Financial ratio analysis can also be used to supplement other forms of analysis, like strategic planning or market studies. For example, financial ratio analysis can be used to replace the number-crunchers that generally go into the company’s annual report.
Examples of Financial Ratio Analysis
A restaurant owner wants to know how much cash her business has on hand. Her backup cash-management plan might be to keep a small amount of money in a savings account or to take out a loan. She will use the cash-flow projection to determine how much cash she has at hand and at her disposal. From the cash-flow projection, she will determine how much revenue her business generates over the next 12 months. Next, the revenue projection is used to forecast how much revenue her business will generate in the year ahead. In some cases, a business may not have actual sales data for the year ahead, instead relying on forecast data to make planning decisions.
Summing up
Financial ratio analysis is a valuable tool to help investors make informed decisions. It can identify areas of inefficiency and waste within a company’s financial statements, helping to identify areas for additional focus and resource allocation. Additionally, financial ratio analysis can be used as a supplement to other forms of analysis rather than being the primary analytical tool. Financial ratio analysis is a powerful management tool that can uncover waste, inefficiency, and inattention within a company’s financial reporting process. It can also tell managers how to make their company’s financial data more understandable and accessible to the public.
