Financial Statement Analysis - An Introduction
The financial statements are usually analyzed through measures called “financial ratios”.
What a Financial Ratio is
A financial ratio is a number that is obtained by dividing one figure by another. These figures are called “ratio data”:
Every financial ratio has a name, and focuses on a given segment of a company. A financial ratio presents a snapshot of a company. The name of the ratio hints at the segment on which it focuses.
An array of financial ratios is useful for obtaining a more comprehensive picture of a company’s performance and financial soundness (strength). The financial ratios reviewed below are those that are more popular among economists and accountants.
Sorting the Financial Ratios
Financial ratios can be divided into categories according to a number of cross-sections. Here they will be sorted into three groups, according to the source of the ratio data, as follows:
Balance sheet ratios - This group consists of ratios calculated from two samples of ratio data taken from the balance sheet.
Profit and loss statement ratios - This group consists of ratios calculated from two samples of ratio data taken from the profit and loss statement.
Combined ratios - This group consists of ratios calculated from two samples of ratio data, one of which is from the balance sheet, and the other from the profit and loss statement.
Acceptable Way in Interpreting and Mentioning Financial Ratios
If, for example, the financial ratio called the “current ratio” is calculated to be 2, then it can be stated that the result of the current ratio is 2. It is more usual, however, to simply state, “the current ratio is 2”, without the word “result”.
Interpretation of the Result of Financial Ratios
As noted below, results that are considered good, or even excellent, for a company in one sector (the steel industry, for example) may be considered poor for a company in another sector (an insurance company, for example) and vice versa.
A company’s performance and dependability can therefore be characterized as either good or bad according to its financial ratios, but only after a thorough review of the sector to which the company belongs and the accepted interpretation of the results of financial ratios in that sector.
Examples from the financial statements of USA Furniture will be used to explain the financial ratios.