Benefits Of Financial Ratios And Analysis

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Introduction Droms and Wright (2010) state, “adequate financial planning is a key element in the success of any business venture. Conversely, the lack of adequate financial planning is a key element in the failure of many business enterprises” (p. 107). For the purposes of this paper, the benefits of using financial ratios to analyze the balance sheet, income statement, and the statement of cash flow will be discussed. The author will choose two key ratios for a review of how they best serve her purposes, and why. Additionally, the dangers of overanalyzing ratios will be discussed and the pitfalls for shareholders, for the owner of a small company, and for a banker assessing risk will be included.
Benefits of Financial Ratios and
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Ratios are used to interpret the financial situation and performance of the company differently depending upon who is assessing the information, what problem they are trying to solve, and/or what decision they trying to make. Balance Sheet. The balance sheet represents the stock of assets, liabilities, equities with in a company; they are used to view the financial condition of a company at a given moment in time (Droms and Wright, 2010, p.33). Ratios that are beneficial to assessing the financial health of the company from the balance sheet include: net working capital, return on assets, and long term debt/equity.
Net working capital is important and beneficial to balance sheet analysis as it reflects the company’s short-term liquidity or ability to meet its financial obligations as they become due (Droms and Wright, 2010, p. 35). This is an important measure for bankers and other lenders as they decide whether or not to fund your company. An increase in net working capital is considered a negative cash flow, making it not available for equity. Net working capital is calculated by subtracting the current liabilities from the current assets. The rule of thumb for bankers and lenders is to have twice the amount of current assets over the current liabilities.
Return on assets measures the company’s ability to turn assets into
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