Financial Ratio Analysis: Assessing Performance and Financial Health

Posted on Jan 19, 2024 at 12:01 AM

Financial ratio analysis is one of the most interesting analytical techniques for companies of all kinds. It helps them assess their financial health and make sure they are on the pathway.

In our article today, we cover the Financial Ratio Analysis and top types. We will mention its use and users and how it works. Read on.

In our article today, we will cover the definition of financial ratio analysis and its popular types. We will also mention to you its uses, users, and how it works in general. 

So read on…

What Is Financial Ratio Analysis?

In a simplified way, financial ratios are means and tools that benefit company owners, business managers, and investors in tracking the financial health of their companies and comparing them with the competition. By using it, the process of analysing the company's financial history may also become true.

As for the financial ratio analysis, it is a quantitative technique of comparing the relationship between two or more elements of the company's financial data by examining the current and previous data, and its role in influencing the company's strength. The financial statements for analysis are the balance sheet, income statement, and net profit statement.

The financial ratio analysis gives an insight into the volume of liquidity, profitability, operational efficiency, the company's market value, and other ratios. This is useful in evaluating and analysing the company's future economic performance and making decisions to improve the profitability, suitability, and liquidity of the company.

Financial ratio analysis also helps track the overall performance of a company by monitoring: 1. Financial Statements. 2. Individual ratios over specific periods. 3. Track the numbers' changes over those periods to identify potential trends.

For example, when the debt-to-asset ratio increases over a period, those indicators mean that debt is starting to accumulate. So here the management and the decision-makers must do something before the default stage.

In addition, the information on the ratios collected is useful in studying and comparing the financial health of the company with the competing companies in the same sector and in the analysis to create ways and methods of business development. So using financial acumen is key beyond decision-making.

Many parties use financial ratio analysis, including:

1. Internal parties such as management, company owners, and employees.

2. External parties such as financial analysts, competitors, regulators, industry observers, creditors, and others.

What are the Top Types of Financial Ratio Analysis?

The types of financial ratios analysis are classified into a group of main types, which include all types of financial ratios included in the analysis, including:

1. Liquidity Ratios:

Liquidity ratios measure a company's ability to meet its obligations and pay off its short-term debts as they become due, using the company's current assets. Liquidity ratios include the current ratio, quick ratio, and working capital ratio.

2. Solvency Ratios (financial leverage):

Solvency ratios compare a company's debt levels with its assets, equity, and earnings, to evaluate the likelihood of a company staying afloat over the long haul. Examples of solvency ratios include debt-equity ratios, debt-assets ratios, and interest coverage ratios.

3. Profitability Ratios:

These ratios convey how well a company can generate profits from its operations (the size of incoming cash flows). Examples of profitability ratios are return on assets, profit margin, and return on equity.

4. Efficiency Ratios ( activity ratios):

Efficiency ratios evaluate how efficiently a company uses its assets and liabilities to generate sales and maximise profits. These ratios also measure the efficiency of implementing the internal operations of companies in the short term. The key efficiency ratios include the fixed and total assets turnover ratios, the inventory turnover ratio, and the day's sales in inventory.

5. Coverage Ratios:

Coverage ratios measure a company's ability to make interest payments and other obligations associated with its debts. Examples include the time's interest earned ratio and the debt-service coverage ratio.

6. Market Prospect Ratios:

These are the most commonly used ratios in fundamental analysis. Investors use these metrics to predict future earnings and performance. Mostly it counts for governmental public companies and it doesn't count for very small companies. They include earnings per share (EPS), price-to-earnings (P/E) ratio, and price-to-cash flow (P/CF) ratio.

How to Use Financial Ratio Analysis?

Usually, companies conduct financial ratio analysis annually or quarterly. The way it works is for the company's expert financial analysts to compile some different financial ratios. And at this point, in particular, the power of their financial literacy in calculating these ratios emerges. These ratios include: the balance sheet, cash flow statement, net profit statement, and traded stock prices (if trading is public).

Analysts collect this information in tables to obtain financial ratios for all elements of the company. Accounting Training courses in Paris can help you learn how to set up and compare these ratios.

As a reminder, these ratios are useful if there are other previous ratios for the same company or current ones for competing companies to compare with. By comparing these ratios with their corresponding ratios, the analyst can diagnose performance and provide reports on the state of the company and advice on how to improve.

For example, a company has a debt-to-asset ratio of 40%, which shows that 40% of the company's assets are debt-financed. Yet this does not mean anything to investors or financial managers!

In your opinion, is this situation a good thing or not for their financial statements?

No one will be able to answer this question unless a comparison is made with a previous ratio of the company or a current ratio of a competitor.

In Conclusion,

Performing accurate financial ratio analysis is one of the most popular methods to gain insight into the financial health of companies and organisations so that they can read their position and make the necessary financial adjustments to improve their financial performance. This is to avoid failure and produce better results. 

We hope that you have found the information you need about this concept.