Financial analysis using ratios between key values help investors cope with the massive amount of numbers in company financial statements. For example, they can compute the percentage of net profit a company is generating on the funds it has deployed. All other things remaining the same, a company that earns a higher percentage of profit compared to other companies is a better investment option.
Financial Ratios Can Measure Different Things
The Net Profit to Capital Employed ratio mentioned above measures the success of a company in using funds available to it. There are ratios to measure the company's:
- Financial health
- Operating performance
- Cash flows and liquidity
Under each category, there are multiple ratios that measure different aspects, or fine tune the measurements. For example, different profitability ratios measure profit margins at different stages, return on owners' funds and effective tax burden.
We will be looking at the different ratio categories in separate articles on:
Ratio Analysis for Investment
Outside investors looking for long-term investment use financial statement ratio analysis to analyze the "fundamentals" of a company. Fundamentals are indicators that point to the potential for long-term success (or otherwise) of a company. Fundamental analysis is different from "technical" analysis that focuses on short-term price movements of a company's shares in the stock market.
Financial statement ratio analysis can help measure a company's:
- Profitability
- Financial structure and position
- Returns provided to shareholders
- Performance compared to peer companies
Ratio Analysis for Business Management
Business managers inside the organization can do ratio analysis to quickly spot problem areas. The analysis might, for example, indicate cash flow problems. It can further reveal that the cash flow problems arise mainly because of slow collection of dues from customers.
Insider managers have access to much more information than what is available in financial statements. In the case of profitability ratios, for example, they have access to the detailed composition of the cost of goods sold. They can thus check which cost element is leading to high costs. They can also analyze the performance of individual business units, and do it on a monthly basis or more frequently.
Financial ratio analysis is typically done to make sense of the massive amount of numbers presented in company financial statements. There are different categories of financial ratios that highlight different aspects of performance. Ratios reveal relationships that can help evaluate the performance of a company, so that investors can decide whether to invest in that company. Analysis can also spot a problem area of operation so that managers can focus on the area.
