Question

why do financial analysts and investors use financial ratios? Classify financial ratios and describe their meaning.

Answer 1

Financial ratio analysis can provide meaningful information about a company’s performance to a firm's management as well as outside investors. Ratios serve as a comparative tool of analysis for liquidity, profitability, debt, and asset management, among other categories—all useful areas of financial statement analysis.

Internal Company Trend Analysis- helps track useful trends in the company's operational performance.

External Industry Analysis -It's useful to understand the average performance of a firm's industry over time as compared to the individual company.

Measuring Up Against Competitors-Companies also often compare their firm's ratios to competing firms. After gathering available ratio data from known competitors and similar firms in the same industry, analysing a firm's performance in relation to its competitors can shed light on any competitive advantages, strengths or weaknesses the company may have and enhance its strategic planning.

FINANCIAL RATIOS

Ratio analysis is the process of determining and interpreting numerical relationships based on financial statements. A ratio is a statistical yardstick that provides a measure of the relationship between two variables or figures.

Financial ratios can be classified under the following five groups:

1) Profitability                                              2) Liquidity

3) Solvency                                                  4) Turnover

5) Efficiency Ratio

Profitability- is used to evaluate the company’s ability to generate income as compared to its expenses and other cost associated with the generation of income during a particular period.

Solvency Ratio- The solvency ratio of an organization gives an insight into the ability of an organization to meet its financial obligations. Solvency also indicates how much the organization depends on its creditors and banks can use this when the organization applies for a credit facility.

Liquidity Ratio – It tells one’s ability to pay off its debt as and when they become due. In other words, we can say this ratio tells how quickly a company can convert its current assets into cash so that it can pay off its liability on a timely basis. Generally, Liquidity and short-term solvency are used together.

Turnover Ratios-The turnover ratios are used to check the efficiency of the company that how it uses its assets to earn revenue. The sales figure is compared with the assets (different assets) to measure how much of the assets are used to generate the number of sales.

Efficiency ratios- It measure the ability of a business to use its assets and liabilities to generate sales. A highly efficient organization has minimized its net investment in assets, and so requires less capital and debt in order to remain in operation.