Ratio Analysis | Financial Statements Analysis - MBA Crystal Ball (2023)

When it comes to analyzing financial statements, you can useFormulas for ratio analysisto interpret the data presented in the financial statements (balance sheet,Win and loss) better. In this article, we'll start with the meaning and definition of ratio analysis, then continue with examples of different financial metrics before concluding with a summary of its limitations.

Introduction to balance sheet analysis

As we know, a ratio shows the relationship between two numbers. It shows how big one number is compared to another.

If we have three apples and two pears, we say we have apples and pears in a 3:2 ratio, or "three is two". This means that for every two oranges we have three apples.

In the world of finance, metrics show the performance of companies in key functions and help managers and investors analyze the operations and sustainability of the companies.

For example, a company's "current ratio" or liquidity ratio indicates the ratio of its current assets (assets that are expected to be cashed in 12 months) to its current liabilities (liabilities that have to be paid off in 12 months).

When we say a company's current ratio is 4:1, or 4, we mean that its current assets are four times its current liabilities - meaning the company can pay its current debt four times.

Applications of Ratio Analysis

Metrics calculated from information in financial statements help investors in three ways:

• They simplify financial statements: KPI analysis is simply information presented in company financial statements. Investors can easily get data from a few metrics instead of trying to understand whole statements.
• They help spot a problematic trend: any type of metric analyzed over a long period of time can indicate a flaw in how a company is functioning. The analysis can also predict the future performance of a company in a specific business aspect.
• They facilitate comparisons: KPIs not only help analyze a company's performance, but also allow a comparison of the performance of two or more companies within an industry or sector.

  For example, two companies in the traditional manufacturing sector can be compared based on their current key figures. For example, a company with a current ratio of 3:1 can pay off its ongoing debt more easily than one with a current ratio of 1.5:1.

  These ratios can be compared to the general standard flow ratio for companies in this sector, which can be 2:1.

Types of financial metrics

In the field of balance sheet analysis, financial metrics fall into the following broad categories: liquidity, solvency, efficiency, profitability, and valuation.

liquidity ratios

Liquiditätskennzahlen zeigen die Liquiditätsverfügbarkeit eines Unternehmens und seine Fähigkeit, kurzfristige Verbindlichkeiten zu erfüllen.

In other words, liquidity ratios are an indicator of a company's ability to pay its current liabilities (debts that have to be paid off within a year). Not only do they indicate the amount of cash they have, but also assets that can be quickly converted into cash to meet their obligations.

Examples of liquidity ratios:Quick ratio (endurance test ratio) and working capital ratio (current ratio).

The quick ratio, or endurance test ratio, measures a company's ability to pay its current liabilities using only its "quick assets" (assets that can be converted into cash within 90 days, including cash itself, alongside short-term investments), marketable securities, etc.).

Formula for ratio analysis:The quick ratio is calculated by adding up all the current assets and dividing that number by the current liabilities.

What does it mean for investors?The quick ratio shows how quickly a company can convert its quick assets into cash to pay its ongoing charges without disrupting its capital assets. This shows the liquidity of the company.

Our second example, the working capital ratio or current ratio, shows whether a company can service its current liabilities with its current assets (assets that can be converted into cash within a year: for example cash and cash equivalents).

Ratio Analysis Formula for Capital Ratio:The working capital ratio is calculated by dividing current assets by current liabilities.

What does it mean for investors?This ratio indicates whether a company has sufficient cash to run its day-to-day operations, which is why it's called the working capital ratio.

solvency ratios

Solvency ratios indicate a company's long-term viability - whether it can meet its long-term obligations to creditors and be self-sustaining. These metrics compare a company's debt to its equity, earnings, and net worth.

Example solvency ratio:gearing.

Gearing is the ratio of a company's debt to its equity. It shows how much of its funds come from banks and other creditors versus how much comes from its shareholders.

Leverage formula:Der Verschuldungsgrad wird berechnet, indem die gesamten Verbindlichkeiten durch das gesamte Eigenkapital dividiert werden.

What does it mean for investors?The lower the level of debt, the better the health of the company, since funding from shareholders and other investors is often considered better than funding from banks and other creditors.

efficiencies

Efficiency metrics show how efficiently a company uses its assets to generate profits or turn its inventories into cash. These metrics measure how quickly a business is able to collect cash from its customers for goods or services supplied to them on credit.

In other words, efficiency metrics reflect how efficiently day-to-day managers are making and selling products to make a profit.

Example of efficiency:Receivables turnover rate.

First, accounts receivable are claims on a company from its creditworthy customers. Receivables turnover rate expresses how efficiently a company collects money owed by its customers for goods or services supplied on credit, or how often (rotus) it collects these amounts per year.

Formula for ratio analysis:If a company's average receivables for a given year is Rs. 1 crore (the average is calculated using receivables at the beginning and end of the year) and it accumulated Rs. 2 crore during the year, its receivables turnover ratio is Rs Rs. 2 crore divided by Rs. 1 crore, so 2.

That means the company collected its receivables twice a year or once every six months.

A company that has a receivables turnover ratio of 4 collected its receivables every 90 days, or four times a year.

What does it mean for investors?The higher the receivables turnover rate, the more frequently the company collects its receivables and the more efficient it is.

profitability metrics

Profitability metrics show how effectively a company is using its assets to generate profits.

Example of profitability metrics:Return on Assets Ratio.

The return on assets compares a company's total net income to the investments in its total assets during a period. It's an important index because the ratio includes capital assets, often the largest investment for most businesses.

Formula for ratio analysis:The return on assets is calculated by dividing the net profit for the year by the average total assets (total assets at the beginning and end of the year divided by two).

What does it mean for investors?A high return on assets indicates that assets are being used optimally; a low ratio indicates that investments in assets are higher than necessary or that the assets are not fully used to generate profits.

valuation ratios

Valuation metrics help investors gauge the value of a company's stock and decide whether to buy, hold, or sell its shares. These metrics also allow them to predict the future of the stock and expected returns.

Example valuation ratio:price-earnings ratio.

The price-to-earnings (PE) ratio is a valuation ratio that compares the price paid for a stock to the earnings it generates. It shows the stock market's assessment of the value of a company's shares based on the declared share profits.

Price to Earnings Ratio Formula:The ratio is calculated by dividing the market value of a share by the earnings per share and is usually determined at the end of a financial year.

What does it mean for investors?The PE ratio indicates the expected price of a stock based on its earnings. It tells a stock buyer what returns to expect from the stock in the form of higher dividends or a higher stock price at the time of sale.

The ratio can be used to compare companies in the same industry, but is susceptible to management manipulation. For example, an extremely high ratio may indicate that earnings have likely been overstated and a stock price decline is imminent.

Therefore, as shown above, financial metrics are figureheads that show a company's performance in relation to various parameters. The ratio analysis shows investors the sustainability and future of their investments.

For example, certain numbers may show that a company is profitable, but the relevant financial metrics may indicate a cash flow problem. Financial metrics, on the other hand, can inform managers about the areas in their companies that need their attention.

Limitations of Ratio Analysis

Although financial metrics and metrics analysis have many advantages, they also have disadvantages:

• Historical or old data feeds into the calculation of financial ratios and ratio analysis, making the information they provide far from up-to-date.
• Various estimates go into calculating financial ratios, and as such, the information that the ratio analysis purports to provide may not be accurate.
• Financial ratios and ratio analysis may not be an appropriate tool to compare companies from different sectors as they may operate in wildly different economic environments.

  They may not even be appropriate for comparing companies from the same industry as they may have different accounting practices and operating policies.

Important financial issues

–Introduction to Finance
—balance sheets
—Win and loss
—cash flow
—Abgezinster Cashflow

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