Financial ratio analysis and how to use it is featured in your Numbers Toolkit. Business owners, analysts, as well as investors all use it. I have a vlog about what financial ratio analysis includes and how it’s used. In it, I talk about the four common areas used in financial ratio analysis, or quadrants as I refer to them there. They are:
- Profitability ratios,
- Liquidity ratios,
- Efficiency ratios, and
- Risk and return ratios.
The video showcases and interprets those ratios with a worked example. So, if you want to find out more (and you’re a visual learner) click on the video below to really grasp this.
Financial statements and their limitations
Your financial statements, profit and loss and balance sheet show your profitability and financial position. These accounts record your performance. However, they are limited in use. This is because no indication is given as to whether the results are favourable or unfavourable.
For example, you wouldn’t see anything in the profit/loss figures that will tell you if those numbers are what the firm in question is aiming for. Whether the figures are satisfactory for the company remains to be the subject of analysis which will have to take into account various parameters. The figures themselves are simply not enough as a measure.
The assets are listed in the Balance Sheet but, again, there is nothing to show that they are being used effectively. For example, is a bank balance of £10,000 a healthy sign and is an overdraft of £5,000 unhealthy?
What you really need to know about the business to be able to do financial ratio analysis
As a business owner, financial analyst, or investor you need the answers to a number of questions:
- How good is your performance?
- Where can I improve the business performance?
- Which problem areas do I need to investigate?
Why and how to compare with competitors
You can get more insight by comparing figures with those of competitors or with the average for the industry. Needless to say that doing a straightforward comparison of figures is usually unhelpful. Because a profit of £20,000 may be acceptable for one firm but entirely unacceptable for another.
To be able to make the comparison more meaningful, one needs to look at how those numbers relate to the capital employed. To illustrate this, we’ll look at this example – a return of £20,000 on capital of £100,000 (20%) is obviously better than a return of £20,000 on capital of £200,000 (10%).
So to recap, knowing how to use financial ratio analysis is beneficial for the purpose of comparison, and gaining insight.
Who is financial ratio analysis for?
Parties who need to understand how to use financial ratio analysis are:
- Owners and investors who want to see how profitable their investment is
- Potential creditors, such as suppliers and banks that need to know if the business is credit worthy
- Staff who are interested in wage rates, bonuses and profit-sharing, which must be considered in the light of profitability
- Companies interested in take-over bids that want to see profitability and efficient use of assets.
We’ll continue this conversation and help each other achieve our financial goals in my Numbers Know How Financial Story Plan Community. So do join us.
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