Financial analysis is like ECG to your business. It tells you how good your company is (Balance sheet), determines the current company’s operational performances (profit and loss statements), and analyzes the durability of the company (cash flow statement).
Primarily its use is to figure out the benefit of an asset for trade or investment. It allows in determining the current positioning of the business with regards to customer base (strengths) and Volatile cost (weaknesses). It provides an understanding of key drivers of the firm with strategic, economic aspects along with accounting and finance, all of which would mention conspicuously different stories.
The types of financial analysis are as follows:
Taking the Financial ratio out of the financial analyses, let us try and understand the four concepts of financial ratio i.e., Liquidity ratio, Profitability ratio, Turnover ratio, and Solvency ratio, taking the following examples. Below are the financial statements of the Company AB Ltd. and ST Ltd.
Balance Sheet of AB Ltd. & ST Ltd (Diagram I)
P&L Statement of AB Ltd. & ST Ltd (Diagram II)
Below mentioned are the examples of financial ratio analysis based on financial statements provided above:
Liquidity Ratio:
Liquidity ratios measure a company’s ability to pay debt obligations and its margin of safety through the calculation of raising its external capital. The two most common types are:
Current Ratio:
This measures the company’s ability to pay short-term obligations or those due within one year. It helps in maximizing the existing assets on its balance sheet to satisfy its existing debt and other payables.
ST’s Current Ratio is better as compared to AB, which shows ST is in a better position to repay its current obligations.
Quick Ratio
It is an indicator of a company’s short-term liquidity position and measures a company’s ability to meet its short-term obligations with its most liquid assets.
ST is in a better position as compared to XYZ to instantly cover its current obligations.
Profitability Ratio
They are used to assess a company’s
ability to generate earnings relative to its revenue, operating cost, balance sheet assets, and shareholders’ equity over time, using data from a specific point in time.The most common types are:
Operating Profitability Ratio
Measures the Operating efficiency of the company. Both companies have a similar Operating Profit Ratio.
Net Profit Ratio
Measures the overall profitability of the company ST has better profitability compared to AB.
Return on Capital Employed (ROCE)
It measures the return realized from the total capital employed in the business. Both companies have a similar return ratio to be provided to all the owners of capital.
Turnover Ratios
It analyzes how efficiently the company has utilized its assets. The most common types are:
Inventory Turnover Ratio
It measures in evaluating the practical level of managing the inventory of the business.
A higher ratio means a company is selling goods very quickly and is managing its inventory level effectively.
Receivable Turnover Ratios
It helps in measuring a company’s effectiveness in collecting its receivables or debts.
Higher the ratio means the company is collecting its debt more quickly and managing its account receivables effectively.
Payable Turnover Ratios
It helps in quantifying the rate at which a company can pay off its suppliers.
Higher the ratio means a company is paying its bills more quickly and able to manage its payables more effectively.
Solvency Ratios
It measures the extent of the number of assets owned by the company to cover its future obligations. Some important solvency ratios are as follows:
Debt Equity Ratio
It measures the amount of equity available with the company to pay off its debt obligations. Higher the ratio represents the company’s unwillingness to pay off its liabilities. Therefore, it is better to maintain the right amount of debt-equity rate to manage the company’s solvency.
Higher the ratio means higher leverage. AB is in a better solvency position as compared to ST.
Financial Leverage
It measures the number of assets available to equity holders of the company. Higher the ratio means higher is the financial risk in terms of debt position to finance the assets of the company.
Higher the ratio of ST implies that the company is highly leveraged and could face difficulty in paying off its debt as compared to AB.
Conclusion
These were the critical financial ratios as they are used by finance professionals in analyzing the financial performance of companies. Also, it helps in understanding the relative performance of two or more companies in the same industry.
