Ratio and Financial Statements Analysis
Kimberly Y. Gruber
University of Maryland University College
Dr. Sunando Sengupta
Turnitin Score: 23%
The purpose of this paper is to examine ratio and financial statement analysis. Such analysis is a useful tool for managers and stakeholders to evaluate a company’s financial health in order to identify opportunities for growth and areas of weakness so as to institute corrective measures. Financial statements are used in order to predict trends of cash flow within the business as well as predict the potential of a business and if they are capable of financial growth. Ratio analysis examines the probability of ...view middle of the document...
Financial statement and ratio analysis is also used to drill down within the larger financial performance of the company as a whole to evaluate various divisions and product or service lines. These analyses are critically important as they are often used to enhance the firm’s credibility in the larger marketplace; assist in determining its own creditworthiness; and comparing its performance to that of potential competitors.
In examining company reports the focus is primarily on revenues (gross profit), and net income (earnings after expenses). For example, Apple Inc., might be interested in conducting a detailed evaluation of its revenue in order to isolate the amount being generated by various products (i.e., the sales of the iPhone compared to the iPad). The revenue report might even assist in identifying the underlying issue, such as lack of advertising, if there is a wide disparity in sales. Evaluating net income helps the financial manager ascertain the amount of profit that the company ultimately gained after expenses, such as manufacturing and advertising, are taken into account. Apple, Inc. can then use the results of these evaluations to make cost-benefit judgments that could lead to new marketing campaigns, redesign, or even potential elimination of a product line.
Types of Ratio Analysis Traditionally the current ratio and the quick (acid test) ratio were used to analyze the short term liquidity of a business. However, these ratios rely exclusively on a business’ balance sheet and are not always reliable indicators due to unpredictable changes in accounting measurement of the values of assets and accrual accounting. In order to overcome the problems associated with accrual accounting and to provide a more precise focus on the cash position of a business the statement of cash flows method was created. This method provided for the creation of a new set of ratios which could be used to analyze the liquidity of a business despite the cash flow detail that was sometimes absent in business that used accrual accounting. Since the introduction of the statement of cash flows a number of ratios have been developed and their use continues to evolve.
Some examples of financial ratios that are used are: the liquidity ratio (i.e., current assets/current liabilities and current assets – inventory/current liabilities) which is a measure of a business’s potential to cover its expenses; efficiency ratio (i.e., inventory turnover = cost of goods sold/inventory; days sales in inventory = 365 days/inventory turnover) which is a measure of the efficacy of a business and the usage of their current assets; and leverage ratio (i.e., total debt ratio = total debt/total assets; debt to ratio=total debt/total equity) which is a method to measure the level of debt in a business and evaluate its potential to meet long term financial goals. There are other methods in use as well such as profitability ratio and market value Indicator.