# USING RATIO ANALYSIS TO UNDERSTAND FINANCIAL STATEMENTS (Part 1)

Written by Kayode Akinbo · 2 min read

The financial statements are no less than the business that is being conducted by well-defined accounting principles. Such statements contain information like balance sheets, performance reports, cash flow statements, and other comparable information that can be analyzed to give a detailed account of the company’s financial position. Ratio analysis is one such method of analyzing a firm’s financial position when compared to others in the same industry or even a benchmarking firm.

What is ratio analysis?

Ratio analysis is a method of analyzing financial statements to calculate and interpret financial ratios. Financial ratios can be used to measure a company’s liquidity, solvency, profitability, and efficiency. Ratios can also be used to compare a company’s financials to industry averages or other companies.

How do you use it?

Financial statements can be confusing, but ratio analysis is a tool that can help you understand them. This technique involves Expressing relationships between different financial statement items as ratios. This makes it easier to compare apples to apples, and spot trends over time.

There are all sorts of ratios you can calculate, but some common ones include:

-Gross margin: This expresses your company’s profitability and is calculated by dividing gross profit by revenue.

-Asset turnover: These measures how efficiently your company is using its assets and are calculated by dividing revenue by total assets.

-Current ratio: This measures your company’s ability to pay its short-term obligations and is calculated by dividing current assets by current liabilities.

Of course, these are just a few examples – there are many other ratios out there that can be useful in different situations. The important thing is to select the right ratios for your needs, and then track them over time to see how your business is doing.

The Importance of Ratio Analysis

When it comes to understanding your financial statements, ratio analysis is key. This type of analysis allows you to see how different aspects of your business are performing about each other and can give you valuable insights into where improvements need to be made.

There are several different ratios that you can use to analyze your financial statements, but some of the most important ones to focus on include:

Liquidity ratios:

Liquidity ratios are financial analysis ratios that are used to determine how liquid a company is. In other words, they determine how fast a company can offset its short-term financial obligations. Because of the dynamic nature of business, different industries have several reasons why they might have more liabilities than others.

Types of liquidity ratios include the following.

The current ratio is a measure of a company’s ability to pay its short-term obligations with its current assets. A high current ratio means that the company has a lot of liquid assets to cover its short-term obligations. A low current ratio means that the company may have difficulty paying its short-term obligations. The formula for the current ratio is current assets divided by current liabilities.

Formula la for a current ratio

Current ratio =     Current asset

Current liabilities

The quick ratio is a measure of a company’s ability to pay its short-term obligations with its quick assets. Quick assets are those assets that can be converted to cash quickly, such as cash and marketable securities. A high quick ratio means that the company has a lot of liquid assets to cover its short-term obligations. A low quick ratio means that the company may have difficulty paying its short-term obligations.

Acid test formula:

Acid test ratio:     Current asset – Inventory

Current liabilities

in