How to use Financial Ratio Analysis is part of your Numbers tool kit. This is part of the tool kit used, the key ratios used by business owners, analysts, and investors. In this vlog I cover the four common areas used in financial ratio analysis,
- Firstly, Profitability
- Secondly, Liquidity
- Thirdly, Efficiency
- Lastly, Risk and return
The video showcases and interprets those ratios with a worked example.
Limitations of financial statements
Your financial statements, profit and loss and balance sheet show your profitability and its financial position. These accounts record your performance but are limited in use. No indication is given as to whether the results are favourable or unfavourable.
For example, they show the profit/loss figure but there is nothing to indicate whether that figure is satisfactory for the firm concerned.
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?
As a business owner, financial analyst, or investor you need a number of questions answered, such as:
- How good is your performance ?
- Seeing where your business performance can be improved
- Problem areas to investigate.
Furthermore, more insight is gained by comparing figures with those of competitors or with the average for the industry.
A straightforward comparison of figures is usually unhelpful.
A profit of £20,000 may be acceptable for one firm but entirely unacceptable for another: if it is related to the capital employed it becomes more meaningful.
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%).
Knowing How to use Financial Ratio Analysis is normally used for the purpose of comparison, and gaining insight.
Good to know
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 who need to 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 who want to see profitability and efficient use of assets.
In the meantime, join me in my Numbers Know How Financial Story Plan Community where we’ll continue this conversation and help each other achieve our financial goals.
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