Financial Ratio Analysis

How can ratio analysis be used to identify a firm's financial strengths and weaknesses?

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Now that you've reviewed the income statement and balance sheets, as well as the financial ratios derived from them, let's examine the profitability ratios derived from both statements. Pay attention to the net profit margin, return on equity, and earnings per share as you read.

How can ratio analysis be used to identify a firm's financial strengths and weaknesses?

Individually, the balance sheet, income statement, and statement of cash flows provide insight into the firm's operations, profitability, and overall financial condition. By studying the relationships among the financial statements, however, one can gain even more insight into a firm's financial condition and performance. A good way to think about analyzing financial statements is to compare it a fitness trainer putting clients through various well-established assessments and metrics to determine whether a specialized fitness program is paying dividends for the person in terms of better strength, endurance, and overall health. Financial statements at any given time can provide a snapshot of a company's overall health. Company management must use certain standards and measurements to determine whether they need to implement additional strategies to keep the company fit and making a profit.

Ratio analysis involves calculating and interpreting financial ratios using data taken from the firm's financial statements in order to assess its condition and performance. A financial ratio states the relationship between financial data on a percentage basis. For instance, current assets might be viewed relative to current liabilities or sales relative to assets. The ratios can then be compared over time, typically three to five years. A firm's ratios can also be compared to industry averages or to those of another company in the same industry. Period-to-period and industry ratios provide a meaningful basis for comparison, so that we can answer questions such as, "Is this particular ratio good or bad?"

It's important to remember that ratio analysis is based on historical data and may not indicate future financial performance. Ratio analysis merely highlights potential problems; it does not prove that they exist. However, ratios can help managers monitor the firm's performance from period to period to understand operations better and identify trouble spots.

Ratios are also important to a firm's present and prospective creditors (lenders), who want to see if the firm can repay what it borrows and assess the firm's financial health. Often loan agreements require firms to maintain minimum levels of specific ratios. Both present and prospective shareholders use ratio analysis to look at the company's historical performance and trends over time.

Ratios can be classified by what they measure: liquidity, profitability, activity, and debt. Using Delicious Desserts' 2018 balance sheet and income statement (Table 14.1 and Table 14.2), we can calculate and interpret the key ratios in each group. Table 14.4 summarizes the calculations of these ratios for Delicious Desserts. We'll now discuss how to calculate the ratios and, more important, how to interpret the ratio value.

Source: OpenStax, https://openstax.org/books/introduction-business/pages/14-7-analyzing-financial-statements
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