Bala is an amateur business man. He recently bought an agri-business simply because he believed that its large size meant it was a well-performing business. Bala is about to find out, in a very catastrophic way, that all that glitters isn’t gold. Don’t be Bala. Get to know what is behind the curtains.
The need to understand the true performance of a business using ratio analysis became evident to me in the past few weeks of our Corporate Financial Accounting sessions.
WHAT IS RATIO ANALYSIS?
Ratio Analysis is a quantitative method of looking at the performance of the business in terms of its efficiency, liquidity, revenue and even profitability tendencies. It is used to assess the relationships between and among items of the financial statement. Ratio analysis is necessary (especially for a potential investor) because it shows trends in the financial activities of the business over time. It is also handy when comparing the business to other businesses at any point in time.
The types of ratio analysis span the different items of the financial statement. However, for the purpose of this thrilling, blood-pumping and exhilarating blog, I’ll contain my excitement and explain major ratio analysis methods. These are; Liquidity ratio and Profitability ratio.
These proportions are used to indicate a business’s capacity to settle debts as soon as they are due. It measures the company’s ability to repay short-term debts (current liabilities) with money from revenue or even assets at its disposal. These could even be unexpected cash needs. Bala would need to know this when deciding where to focus his financial efforts. The ratios involved in this analysis are:
Current Ratio: This ratio considers and assesses the capacity of a company to sort out its current/immediate financial obligations using its current assets like inventory, account receivables and cash etc. Can the business pay its debts in 12 months? It is also known as the working capital ratio. It is derived by dividing the current assets by the current liabilities.
Quick Ratio: Also known as the acid test ratio, the quick ratio determines whether the business can use cash or cash equivalents (“quick assets”) to stamp out any immediate financial obligations. Quick assets are items that can be converted to cash in a relatively short amount of time. Quick assets are also known to be insusceptible to the risk of change in value
It is widely understood that the fundamental goal of most businesses is to make profit. The profitability ratio, also known as the operating margin addresses the company’s capacity in this regard. It shows how the business will effectively generate revenue and, more so, profits from its operations. The metrics involved in this analysis are:
Profitability In relation to investments
Return on Assets: If Bala wanted to know how efficiently the assets of the business are used to generate profit, this is the ratio he would use. Simply put, the higher this ratio, the more effective the company is at using their assets to generate income.
Return on Equity: This ratio indicates how good the business is at creating profits from the funds invested in it. It shows how the business succeeds or fails at turning shareholder capital to net income.
In conclusion, before making huge investments in businesses, it is helpful to look under the hood and not be deceived by the surface-level posterity.
Love and Light.