RATIO AND FINANCIAL STATEMENT ANALYSIS

Executive Summary

This paper is in a form of essay which enlists the ratio and financial statement analysis of companies. Ratio analysis is important for a company to analyze their strength and weaknesses from past and future. Moreover, financial statement of companies are also discussed in the essay, which helps in making financial decisions for the company. Limitations and advantages are also discussed in the study which explain, the need and challenges to be kept in line by companies.

RATIO AND FINANCIAL STATEMENT ANALYSIS

Ratio analysis:

Ratio analysis is a form of analysis, which is used to get a rapid indication about a company’s financial performance in various key areas. These ratios are further divided into solvency ratios, profitability ratios, liquidity ratios, efficiency ratios, coverage ratios, and market prospect ratios (Al-Nimer & Sleihat, 2015). These ratios are also further divided into subcategories, which help in making assumptions about the financial condition of a company in present and in future. For companies, ratio analysis is selected as the first step for making assumptions only and it is not effective in the longer term. It can also help the company to compare its financial performance with the industry and competitors. These ratios give an overview to the directors of the company, that where the company has done well and where improvement is needed.

Data included in the ratio analysis is usually taken from the historic financial resources of the company, which makes it easy for the management to get assumptions from it and improve in the area which is not doing well.

Liquidity ratios helps a company to calculate its ability to pay the short term debts which comes from the quick or current assets. Companies use liquidity ratios to examine the concerns which indicate the positioning of cash flows (Al-Nimer & Sleihat, 2015). This type of ratio is calculated internally or externally based on the type of organization. It is usually in a comparison, which includes the previous statements and the current operations of the company. Ultimately it helps in making assumptions, that the company was performing better in the past or in present (Al-Nimer & Sleihat, 2015). A higher liquidity ratio indicates that a firm has more capability to cover its short term outstanding debts. Externally, companies compare themselves with their competitors in an industry. Based on the results, companies try to make strategic decisions comparing their competitors. Liquidity ratios can be measured from current ratio, working capital ratio, and quick ratio.

Solvency ratio helps a company to measure, whether the firm’s cash flow is good enough to cover its short and long term liabilities. Solvency ratio compares the liability levels with the equity, assets, and earning of a company to measure, that the company can pay off its short and long term debts or not (Al-Nimer & Sleihat, 2015). A lower solvency ratio indicates that, the company has enough cash flow to cover their debt obligations. Solvency ratio can be measured using debt-to-equity ratio, debt-to-asset ratio, and interest coverage ratio. Instead of calculating the income of a company, solvency ratio measures the cashflow of a company which gives an overview to the management that how much cash flow they have and what will they earn after paying their long/short term debts (Al-Nimer & Sleihat, 2015).

Profitability ratios tells a company that how well can they gain profit from the operations. It helps a company to analyze that how much they can gain from the operations of the company, compared to the expenses incurred over a certain period of time (Saleem & Rehman, 2011). profitability ratio can be measured using Return on Assets (ROA), and profit margin ratio. A good profitability ratio must be higher, which shows that the company is earning more than the expenses incurred by the company. This ratio also compares with the competitors earning, to make analysis that where the company lies as compated to the competitors of the industry (Saleem & Rehman, 2011). A lower ratio will ultimately mean that the firm does not earn so well, and need to make adjustments in the operations.

Efficiency ratio helps a company to measure how well they utilize their assets and liabilities to increase sales and profit margin. It analyzes a firm’s short term or current performance by managing the assets and liabilities of the company. A lower efficiency ratio indicates, that the company has less costs applied in their assets and liabilities, and the company is selling much more than that. Efficiency ratio can be measured using A/R turnover, sales to inventory, sales to net working capital, accounts payable to sales, and stock turnover ratio (Saleem & Rehman, 2011).

Then, there are coverage ratios, which tells the ability of a company to pay its interest in the market and other financial implications. Using coverage ratios in the financial report, can tell about the level of company’s commitment towards paying the interests which are mandatory for the company (Siddiqua et al., 2016). However, a higher coverage ratio is meant to be benefical in terms of paying loans and interests to their lenders. Looking into the financial statements of the company, identifies that how much interest is payable in a given time. coverage ratios include Interest coverage ratio (ability of a company to pay interest expense on its debt), debt service coverage ratio (ability of a company to pay its entire liability), and asset coverage ratio (ability of a company to pay off its debt service in terms of balance sheet).

Market prospect ratio is used to measure the amount/cash which a company expects to receive from their investments. It can be a dividend yield, shares in a corporation, stocks acquired by a company, and the stock price. Simply, it helps to examine that what will a company get from its investment. It gives an idea to the directors, that how much the stock price will be in the future based on the current investments. A higher market prospect ratio means, that the company will get higher returns from their investments in the future (Siddiqua et al., 2016).

All these ratios serve the same purpose for the company. It depends upon the company to choose which ratio they want to use, in given circumstances. Using ratio analysis in a company helps them to identify their financial position, that where our company is standing as compared to the competitors. It also helps in making investment decisions in the future, and analyzing that how much the company should invest and what will they get in the future. By doing a ratio analysis, helps a company to make evaluations on the accounting figures which can deviate from each financial term (Siddiqua et al., 2016). It also helps in making efficient operational analysis, that the company is making positive operations or not. The values of these ratios (higher or lower) helps to make assumptions about the future of the company. Most importantly, it helps in forecasting the company’s entire growth, and the ability to respond to external factors in the market (Siddiqua et al., 2016). By forecasting, a lot of errors are eliminated regarding the financial statements of the company.

Financial statement analysis:

Financial statement analysis is a procedure of analyzing and evaluating a firm’s balance sheet or profit and loss statements. This analysis is done to review the financial health of a company, and in return make more effective decisions for the company (Grant, 2016). These analysis record the company’s data to make a company more benefical to their stakeholders, shareholders, managers, and investors.

By implementing financial statement analysis, helps a company to establish trends by comparing the ratios in different time periods of the company. What was the company doing in the past and what it is doing in the present. The analysis in result, helps to measure the profits, liquidity, and cash flow of the company (Grant, 2016). Financial statements includes balance sheet, income statement, and cash flow statement. Balance sheet is a detail of a company’s assets, liabilities, and shareholders equity. The total assets and total liabilities (including shareholders’ equity) should be equal in amount, otherwise it means the company is not managing its operation in terms of assets and liabilities.

The income statement gives an overview of the company’s sales and ends up showing the net income of the company. It gives values of gross profit, net profit, and operating profit to do analysis in the future (Wahlen, Baginski & Bradshaw, 2014). The cash flow statement gives an overview of a company’s cash flow in terms of their operating, investing and financing activities in the whole year. The values provide the description of what the company has been investing in their operations, financies, and investments.

There are always some limitations to using these analysis, which can be vital in decision making for the company. Researchers might take values from the previous statements, which are not the current values and make assumptions on that which can lead to disruptive results (Wahlen, Baginski & Bradshaw, 2014). Keeping in mind the sales of the company, same issue can occur there as well as sales area is always fluctuating in the company. Most importantly, it gives a budget outline to the company for their future that what do they have on hand and what can be utilized from it (Bruce-Twum & Mensah, 2015). Making forecasting on the financial reports will ultimately help the company to be more productvie and operational in the practical environment. Along with the these analysis, it also helps a company to create opportunities of improvement in the area which is not of great interest for the company.

Conclusion

Relating to the real life scenarios, these analysis can be benefical for the banking, logistics, and commercial sector. Multinational firms can also gain a lot of advantage in their processes as these analysis can make a huge impact on the internal and external aspects of the company. Companies should use these ratios and financial statement on annual or semi annual basis to make sure that their operations and financials are in line and if there is any need for improvement, it should be catered on time.

References

Al-Nimer, M., & Sleihat, N. (2015). The effect of profitability ratios on market capitalization in jordanian insurance companies listed in amman stock exchange. Journal of Economics and Sustainable Development, 6(6).

Bruce-Twum, E., & Mensah, C. C. (2015). Financial Statement Analysis.

Grant, R. M. (2016). Contemporary strategy analysis: Text and cases edition. John Wiley & Sons.

Saleem, Q., & Rehman, R. U. (2011). Impacts of liquidity ratios on profitability. Interdisciplinary Journal of Research in Business, 1(7), 95-98.

Siddiqua, A., Chowdhury, A. M. H., Siddikee, M. J. A., Chowdhury, A. S. M. M. H., & Parvin, S. (2016). Key Ratios Analysis between Conventional and Islamic Banking in Bangladesh. Global Disclosure of Economics and Business, 5(2), 77-84.

Wahlen, J., Baginski, S., & Bradshaw, M. (2014). Financial reporting, financial statement analysis and valuation. Nelson Education.