Financial Ratio Analysis is the calculation and comparison of main indicators - ratios which are derived from the information given in a company's financial statements(which must be from similar points in time and preferably audited financial statements and developed in the same manner). It involves methods of calculating and interpreting financial ratios in order to assess a firm's performance and status. This Analysis is primarily designed to meet informational needs of investors, creditors and management. The objective of ratio analysis is the comparative measurement of financial data to facilitate wise investment, credit and managerial decisions. Some examples of analysis, according to the needs to be satisfied, are:
The informational needs and appropriate analytical techniques needed for specific investment and credit decisions are a function of the decision maker’s time horizon(short versus long term investors and creditors). A pervasive problem when comparing a firm’s performance over time(trend or time series analysis) or with other firms(cross sectional or common size analysis) is changes in the firm’s size over time and the different sizes of firms which are being compared. However, one approach to this problem is to use common size statements in which the various components of the financial statements are standardized by expressing them as a percentage of some base (base in the income statement is sales and base in the balance sheet is total assets). See sample file below for further understanding.
In general, a process of standardization is being achieved by the use of ratios. They can be used to standardize financial statements allowing for comparisons over time, industry, sector and cross sectionally between firms and further facilitate the evaluation of the efficiency of operations and/or the risk of the firm’s operations regarding the scope and purpose of evaluation. Ratios measure a firm’s crucial relationships by relating inputs(costs) with output(benefits) and facilitate comparisons of these relationships over time and across firms.
Many attractive categories of financial ratios and numerous individual ratios have been proposed in the literature. The most prominent literature on financial analysis - though non-exhaustive - indicates the following categories of ratios:
Word of caution: Inflation should be taken into consideration when a Ratio Analysis is being applied as it can distort comparisons