USE OF RATIOS IN FINANCIAL STATEMENT ANALYSIS

One of the most frequently used tools for analysing financial statements are financial ratios. Ratios provide vital insight into a company’s financial position and performance. They provide for a standard, fast and easy evaluation of the financial performance of the company being analysed and can quickly be used to compare different aspects of a company’s financials to make conclusions on its financial health and can help identify its strength and weaknesses. Some of the reasons why ratios are frequently used include.

1. They simplify complex financial information and make for easy interpretation and quick identification of areas of strengths or weaknesses.
2. They make for easy comparison between different companies in the same industry for performance measurement, financial position and trend identification and analysis.
3. Ratios are derived with standard formulas and so make for a standardized measure of comparing financial information for different companies irrespective of size or other factors.
4. They provide straightforward and useful insight into a company’s financial position and can play an important role in decision making for investors, creditors and other stakeholders.

There are several ratio categories and some of the common ratios used in analysing company’s financial performance and position are:

• Liquidity Ratio: These ratios measure a company’s ability to pay its short-term debt and meet its cash flow needs e.g., current ratio, acid test ratio etc.
• Profitability Ratios: These ratios are a measure of a company’s ability to generate profits over a period of time. e.g., Gross profit Margin, Asset Turnover etc.
• Solvency Ratios: These ratios indicate the company’s ability to meet its long-term obligations and its ability to remain a going concern e.g., Debt-to -equity ratio, interest coverage ratio etc.
• Efficiency Ratios: These ratios measure how efficiently a company uses its assets to generate revenue e.g., Inventory turnover ratio.
• Investment Ratios: these ratios measure the profitability of a company to its shareholders e.g., Earnings per share, Book value per share.

When these ratios are analysed over time and a comparison made to a benchmark company, an analyst may gain better insight into a company’s financial performance to make investment decisions.

While ratios are a straightforward and essential tool needed for financial statement Analysis, they are not the singular tool used as analysing a financial statement to make useful and informed business decision requires several other measures and factors. Measure like, corporate governance structures and company management, company policies etc are equally useful in analysing a company’s performance.

Also, in addition to ratios, an individual analysing a company may also find it important to perform SWOT analysis, trend analysis and business model analysis of the company to gain better insight into the company’s financial position and performance.

In summary, since ratios are not without limitations, it is important that they are used in combination with other analytical tools and other qualitative information to arrive at a more robust evaluation of a company before final decisions and recommendations are made by an analyst to investors and other stakeholder.