Financial Ratio Analysis
Use Financial Ratio Analysis To Turn Accounting Numbers into Intelligent Business Information.
What is financial ratio analysis? Though financial statements such as Balance Sheet and the Statement of Income are important, but for successful financial management , we must know how to interpret those financial statements using Financial Ratio Analysis to analyze the success, failure, and financial health of a business.
Financial Ratio Analysis enables the business owner/manager to spot trends in a business and to compare its performance and condition with the average performance of similar businesses in the same industry. To do this, compare your ratios with the average of businesses similar to yours and compare your own ratios for several successive years, watching especially for any unfavorable trends that may be starting. Ratio analysis may provide the all-important early warning indications that allow you to solve your business problems before your business is destroyed by them.
Current Ratio = Current Assets / Current Liabilities
Quick Ratio = Quick Asset / Current Liabilities
Quick Assets = Current Assets – Inventories
Net Working Capital Ratio = Net Working Capital / Total Assets
Net Working Capital = Current Assets – Current Liabilities
Return on Equity (ROE) = Net income / Average Stockholders’ Equity
Return on Common Equity (ROCE)= Net Income / Average Common Stockholders’ Equity
Profit Margin = Net Income / Sales
Earnings Per Share (EPS) = Net Income / Number of Common Shares Outstanding
Assets Turnover Ratio = Sales / Average Total Assets
Accounts Receivable Turnover Ratio = Sales / Average Accounts Receivable
Inventory Turnover Ratio = Cost of Goods Sold / Average Inventories
Debt to Equity Ratio = Total Liabilities / Total Stockholders’ Equity
Interest Coverage Ratio = Income Before Interest and Income Tax Expenses / Interest Expense
Income Before Interest and Income Tax Expenses = Income Before Income Taxes + Interest Expense
Price Earnings (PE) Ratio = Market Price of Common Stock Per Share / Earnings Per Share
Market to Book Ratio = Market Price of Common Stock Per Share / Book Value of Equity Per Common Share
Dividend Yield = Annual Dividends Per Common Share / Market Price of Common Stock Per Share
Book Value of Equity Per Common Share = Book Value of Equity for Common Stock / Number of Common Shares
Dividend Payout Ratio = Cash Dividends / Net Income
Return on Assets (ROA) = Profit Margin X Assets Turnover Ratio
Finance impacts on all segments of an organization. It acquires funds, allocates resources and track performance. In a profit-oriented company, the financial statements form the basis for the shareholder’s assessment of management’s records. It becomes a focal point for managerial attention, decision making and accountability.
However, if people aren’t able to link financial strategy with operational strategy, it’s hard for them to see the implications of one for the other – example, where the tight control of working capital can restrict stock availability for customers. So it is important to find a way to engage all business managers in the financial view of the business. Only then you can be sure that they are making the best use of its resources. This is where financial ratio analysis can assist to interpret the financial picture in layman’s language for business managers to grasp the financial implications of business decisions.
Financial ratio analysis therefore allows you to understand the financial statements and develop a better understanding of financial implications resulting from business decisions, helps to create business strategies and develop a thorough understanding of the financial drivers in your business. The interpretation of financial and accounting ratios gives you an understanding of the key drivers behind the financial performance of the business. It clarify the impact of changes to critical drivers and your bottom line through financial modeling and enables you to develop and test financial and commercial objectives to improve your business.
The identification and knowledge of all vital financial data will enable you to have a comprehensive understanding of your business operational performance, and enable you to measure its success. Financial ratio analysis enable you to identify and measure the most critical business performance measurements. These mainly cover five aspects of a business which are profitability, balance sheet & working capital, cash flow, return on assets & investment, and funding requirements.
Accounting is often called the language of business and as such, it is very important for all staff to be familiar with this very critical functional area. Business people should be competent in the understanding and the use of accounting information for financial ratio analysis.
They must comprehend the nature and purpose of accounting,the ways accounting events are measured, recorded and reported and how accounting information is used by both internal and external decision makers. It is necessary to develop skills in analyzing accounting reports using financial ratio analysis and evaluating organizational performance and skills in analyzing costs for product costing and pricing and in making other short term decisions
So what are the critical numbers usually highlighted by financial ratio analysis? The majors ones would be gross margin and profit before tax for profitability focus. collection period and inventory turnover to highlight efficiency, total debt to equity ratio and current ratio to represent solvency. One of the most comprehensive financial ratios for a company would be the dividend yield ratio. The gearing ratio, asset turnover ratio, profit margin, effective tax rate and payout ratio all correspond to key steps in the business process.