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Ratio Analysis

Analysis of Ratios

Analysis of ratios is often carried out by comparing financial ratios annually. A Year-on-Year comparison is the most common practice and is most often required by local law to be presented to the stake holders of a company. However, most companies carry out analysis of ratios for shorter periods to evaluate their performance internally. Comparisons are also carried out with competitor's financial ratios that would be available publicly.

Ratios are evaluated from the numbers of the current year and compared with the previous five years to deduce a financial trend in the business. This will help in comparison with similar businesses of other companies, other businesses within the same company and the company as a whole. With the analysis of ratios, the financial officer is able to deduce the financial state of the business for the top management to be able to make appropriate decisions regarding financial strategies such as to profit or liquidate the business.

Calculating Ratios

In order to calculate ratios, one needs to be aware of the ratios that accurately indicate key data from financial statements. To calculate ratios the financial officer of a company uses various fundamental ratio analysis methods by extracting the relevant financial data from balance sheet, profit & loss statements and cash flow statements.

There are various indicators or ratios in accounting that can be used to analyze financial state of a company:

- Solvency: To determine the solvency of a company, the company's financial officer needs to understand if the company is paying its creditors and has enough working capital. Current ratio also called quick ratio and acid test ratio is commonly used to determine the solvency.
- Profitability: To calculate ratios while preparing the profit and loss account, the company's financial officer evaluates the company's profitability vis-à-vis the levels of turnover, value of assets, capital amount invested in the business and the number of employees contributing. The ratios in accounting to determine the profitability of the company are Gross Profit Margin, Break even point analysis, Net Profit Margin, and Return on Assets
- Business Performance: To calculate ratios to determine the overall business performance of the company, the company's financial officer needs to check for the performance of the individual aspects of the business. To determine these, the ratios in accounting include Borrowing Ratio, Average collection period, Creditor Days, Stock Turnover and Overheads within Turnover.

With the help of the ratios given above a company's financial officer can accurately present a report about the financial state of the company. Analysis of the ratios provided to the top management indicates the overall business performance of the company.

Leverage Ratios

Leverage ratios are used to determine the financial leverage of a company. Leverage ratios help in gauging a company's ability to deal with financial obligations or the methods used by the company to finance its businesses. The main ratio calculated is Debt-to-Equity ratio. Many companies calculate the degree of operating income as a good indicator for leverage ratios.

In this way, the financial officer of a company can use the financial statements of the company to conduct a thorough analysis of ratios in order to help the top management decide about important decisions for the profitability, solvency and liquidity levels of the businesses of the company. Most companies hire financial consultants to carry out analysis of ratios.