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Financial ratio analysis

Temitope Adeyanju Written by Temitope Adeyanju · 1 min read >

Almost everyone needs financial ratio analysis. Banks need to know if a borrower will be able to pay back the loan he is requesting; both the principal and interest. As well as, if he will be able do so within a specified time period. A manager is concerned about the company making the best use of the resources available. An investor needs assurance that his investments are worthwhile and safe. An employee is concerned with the company’s ability to pay his salaries in foreseeable future. Financial ratio analysis will address all these concerns.

“Financial analysis (also referred to as financial statement analysis or accounting analysis or analysis of finance) refers to an assessment of the viability, stability, and profitability of a business, sub-business or project. Often done by professionals who prepare reports using ratios and other techniques; that make use of information taken from financial statements and other reports”.

Wikipedia

The data needed for financial analysis is primarily from the company’s annual report. We can equally get data from secondary sources such as: electronic media, stock market (for publicly-traded corporations), etc. Sometimes though, we may need economic information about consumers’ spending, producers’ price, consumers’ price, and other.

Note however, that while you do your analysis and interpret; you still need to ask yourself some pertinent questions to ensure your interpretation is correct. Such questions as:

  • Is this a regulated company?
  • Has the company just recorded an extra ordinary loss recently?
  • Is the company developing a new product?
  • Or did it just acquire another?

It is important to ask the above questions, because they help to explain the company’s present condition that can affect future prospects.

Financial ratio

A ratio is defined as the quantitative relation between two amounts, showing the number of times one value contains or is contained within the other. Hence, financial ratio compares between one financial information against another. It evaluates company’s performance and its financial condition.

We will discuss some ratios focusing on operating performance and financial conditions. Here are some of them:

  • Liquidity ratio
  • Profitability ratio
  • Activity ratio
  • Financial leverage ratio
  • Return on investments
  • Shareholder ratio

Liquidity ratio:

This ratio seeks to explain a company’s ability to meet its immediate obligations with the use of its short term resources that is current assets . Current assets can be found in the balance sheet, they are resources held by a company to carry out its day-to-day activities, they include cash and other resources that can be easily converted to cash.

Liquidity of a company can be measured using current ratio, quick ratio or acid test ratio and net working capital to sales ratio.

  1. Current ratio: This type of liquidity ratio, compares a company’s current asset to current liability. This will help to show if the current asset can satisfy its current liabilities.
  2. Quick ratio: This ratio shows how easy a company can settle or satisfy its current liabilities with its most liquid current assets. Where, most liquid current asset is total current assets less inventory.
liquidity ratio formula – credit: www.double-entry-bookkeeping.com

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