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:
or Return on Equity (ROE), in times = Net Income ÷ (Average Equity during the period)
Very often, the reported profits are adjusted to reflect sustainable levels of performance and thus instill more meaning to the computation and interpretation of the financial ratios. In this context, EBITDA is used, which is calculated by excluding from the profit figure the tax, interest, depreciation and amortisation amount. Non-reccuring expenses or income is also excluded when this can be substantiated to enhance the interpretation of the derived ratio figures. EBITDA figure can be used as an approximation of the underlying cash flows which at the same time incorporate the future potentials of the company's profitability rather than just the cash generation of a financial year.
Where "Av.", is the Average amount of the opening and closing balance of the corresponding account of the financial year the Analysis is being undertaken.
Each category can be further utilized and an in-depth analysis can be adopted to reflect the corresponding needs of each user, i.e. a bank considering whether to lend a specific company would focus more on financial and liquidity - as the risk of lending to a company that does not have the resources to repay the loan is of great concern for a bank - and profitability ratios, to see whether the company's earnings are adequate to cover the interest on the loan. An analysis from an investor's point of view on the other hand would focus more on profitability and investment ratios, to evaluate the prospects of his potential returns.
Note that there is no absolute guidance or specific definition of ratios and therefore special consideration should be undertaken when ratios are used to make comparison either in a cross-sectional analysis or Inter-firm (as described above).