Question

In a Financial Statement Analysis Report, what is the most useful analytical tool ? Why? In what capacity would you use this analytical tool in business career?

Answer 1

Ratio Analysis is the most useful financial analysis tool used in the market by an analyst, experts, internal Financial Planning & Analysis department and other stakeholders. Ratio Analysis has various kinds of ratios, which can help in commenting on

• Profitability Ratio Analysis
• Rate of Return Analysis
• Solvency Ratios
• Liquidity
• Coverage of Interest or any cost
• Comparing any component with turnover

Effective planning and financial management are the keys to running a financially successful small business. Ratio analysis is critical for helping you understand financial statements, for identifying trends over time and for measuring the overall financial state of your business. In addition, lenders and potential investors often rely on ratio analysis when making lending and investing decisions.

Ratios are critical quantitative analysis tools. One of their most important functions lies in their capacity to act as lagging indicators in identifying positive and negative financial trends. The information a trend analysis provides allows to you to make and implement ongoing financial plans and, when necessary, make course corrections to short-term financial plans.

Ratio analysis also provides ways for you to compare the financial state of your business against other businesses within your industry or between your business and businesses in other industries. The sheer numbers of available financial ratios makes it important to research and choose ratios most applicable to your business.

Common Size Comparison Ratios

Balance sheet common size ratios are important for making comparisons of assets and liabilities. These financial ratios focus on calculating each asset on the balance sheet as a percentage of total assets and each liability as a percentage of total liabilities plus owner’s equity. Calculating and comparing common size ratios for corresponding reporting periods in two consecutive years helps you identify trends such as decreasing cash and increasing accounts receivable balances. Financial planning goals might then include strengthening your accounts receivable collection policy and tightening credit-granting guidelines.

Turnover and Efficiency

Operating expense and turnover ratios are critical for helping you assess how efficiently your business is utilizing assets and managing liabilities. An operating expense ratio compares operating expenses such as rent, inventory purchases and advertising to sales revenue. While a low ratio indicates your business is managing expenses successfully, a high ratio signals a need to course-correct ongoing financial plans.

Turnover ratios typically need deeper analysis, with both extraordinarily high and low ratios indicating a cause for concern. For example, a high inventory turnover ratio indicates a need to review the inventory budget, because your business could be losing sales due to frequent stock-outs.

Cash and Liquidity

Cash and liquidity ratios help determine whether you can afford to invest in capital assets or long-term business growth. A current and working capital ratio both are useful for assessing whether your business has enough liquidity to pay for daily operating and short-term debt expenses. For instance, a current ratio compares current assets to current liabilities. A ratio of 3 to1 indicates that your business is sufficiently liquid. At this point, you can begin incorporating capital or market investments into your financial plan.