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
A balance sheet is a statement of the assets and liabilities of a business going into depth of what the balance of income period.
A balance sheet gives an overall picture of a company's financial situation by showing the total assets of a business, including liabilities plus equity. Current assets can include cash, accounts receivable, inventory and prepayments for insurance. The balance sheet is used by investors to get an idea of what the shareholders have invested, including
Working capital is the money that a company has after paying off its current liabilities and with which it can finance its operating and working capital requirements. The higher a number the better a company is able to pay off its debt and have cash for meeting its financial obligations. The current ratio is used to gauge a company 's ability to pay back its short-term liabilities (debt and payables) with its short-term assets (cash, inventory, receivables). The higher the current ratio, the more capable the company is of paying its obligations. A ratio under 1 suggests that the company would be unable to pay off its obligations if they came due at that point. The current ratio denotes the efficiency of a company 's operating cycle or its ability to turn its products into cash, which is a key requirement for business success. Quick ratio is an indicator of a company 's short-term liquidity. The quick ratio measures a company 's ability to meet its short-term obligations with its most liquid assets, essentially cash and cash equivalents. The higher the quick ratio, the better the financial position of the company in terms of its ability to meet its liabilities.
Ratios are highly important profit tools in financial analysis that help financial analysts implement plans that improve profitability, liquidity, financial structure, reordering, leverage, and interest coverage. Although ratios report mostly on past performances, they can be predictive too, and provide lead indications of potential problem areas. Financial ratios are important because they help investors make decisions to buy hold or sell securities.
There is a essential use and limitations of financial ratio analysis, One must keep in mind the following issues when using financial ratios: One of the most important reasons for using financial ratio analysis is comparability and for this, a reference point is required. Usually, financial ratios are compared to historical ratios of the business itself, competitor’s financial ratios or the overall ratios of the industry in question. Performance may be adjudged as against organizational goals or forecasts. A number of ratios must be analyzed together to get a true and reliable picture of the financial performance of the business. Relying on each ratio
The Balance Sheet is another type of financial statement used by a company to see a snapshot of the company's financial position at a particular point in time. It lists the value of the company's assets followed by its liabilities. A balance sheet can be summed up by a simple equation:
The balance sheet is one of the major and critical financial statements that show the financial position of the company. The balance sheets tell the user of the
The paper illustrates that financial ratio analysis is an important tool for firm’s to evaluate their financial health in order to identify areas of weakness so as to institute corrective measures.
Ratios are important in any type of business, because ratios are sued all the way across the board. many financial ratios are used for the purpose of credit analysis, to see where a company stands financially. The three types of ratios are liquidity, solvency, and profitability. Within these main ratio types there are also 8 other basic types of ratios.
Working capital is the money that a company has after paying off its current liabilities and with which it can finance its operating and working capital requirements. The higher a number the better a company is able to pay off its debt and have cash for meeting its financial obligations. The current ratio is used to gauge a company's ability to pay back its short-term liabilities (debt and payables) with its short-term assets (cash, inventory, receivables). The higher the current ratio, the more capable the company is of paying its obligations. A ratio under 1 suggests that the company would be unable to pay off its obligations if they came due at that point. The current ratio denotes the efficiency of a company's operating cycle or its ability to turn its products into cash, which is a key requirement for business success. Quick ratio is an indicator of a company's short-term liquidity. The quick ratio measures a company's ability to meet its short-term obligations with its most liquid assets, essentially cash and cash equivalents. The higher the quick ratio, the better the financial position of the company in terms of its ability to meet its liabilities.
A Balance Sheet is a snapshot of an organization’s assets, liabilities, and owners’ equity at any given time. It allows the stakeholder’s to see the company's financial condition, as well as, presenting what is owned and owed. Assets are the things that are owned, and are referred to as capital. Liabilities are the amounts owed to others. In order to get an accurate picture, one must look at the whole document, and make comparisons amongst different line items.
The calculation of ratios is the calculation technique for analyzing a company’s financial performance that divides or standardize one accounting measure by another economically relevant measure. Financial ratios can be used as a tool to demonstrate financial statement users for making valid comparisons of firm operating performance, over time for the same firm and between comparable companies. External investors are mostly interested in gaining insights about a firm’s profitability, asset management, liquidity, and solvency.
This measures the adequacy of the company’s working capital position and is as important as measuring the company’s ability to manage its two important assets, inventory and accounts receivable, efficiently.
Firms and Companies include ‘Ratios’ in their external report to which it can be referred as ‘highlights’. Only with the help of ratios the financial statements are meaningful. It is therefore, not surprising that ratio analysis feature are prominently in the literature on financial management. According to Mcleary (1992) ratio means “an expression of a relationship between any two figures or groups of figures in the financial statements of an undertaking”.
Ratio analysis is generally used by the company to provide some information on how the company has performed during that year, so that the parties involved including shareholders, lenders, investors, government and other users could make some analysis before making any further decision towards that particular company. As mentioned by Gibson (1982a cited in British Accounting Review, 2002 pg. 290) where he believes that the use of ratio analysis is such an effective tool to evaluate the company’s finance, and to predict its future financial state. Ratios are simply divided in several categories; these are the profitability, liquidity, efficiency and gearing.