Financial statements are used for a number of reasons such as assessing profitability and financial risk. A lender for example would look at a company’s financial statements, do a number of calculations and address the relative financial risk/risk of defaulting. Module 5 is all about analysing these “numbers” to make informed financial decisions.
Ratios:
Ratios are used to express relationships among various items from the financial statements of an annual report. Ratios are standardised formula that incorporates a number of variables within the financial statements. They allow an analyst to better understand the numbers contained in the financial statements.
Types of Ratios:
In financial statement analysis there are five types of ratios:
Profitability:
Profitability ratios access the firm’s ability to use its resources to obtain a profit. Two ratios include Return on Assets and Return on Equity
Efficiency Ratios:
These are ratios that address the firm’s efficiency in using its resources. There are three efficiency ratios, A/C receivable turnover, Inventory turnover and fixed asset turnover.
Financial Leverage (gearing):
Financial leverage (gearing) ratios measure a firm’s long term financial risk. It examines a firm’s ability to meet interest and principal payments on their long term debt. Ratios include the gearing ratio and interest coverage ratio
Liquidity:
Liquidity addresses short term financial risk. In other words it accesses the firm’s ability to pay debt as it falls due. Ratios include acid test ratio and cash flow from operations ratio.
Market/investment ratios:
Market/investment ratios compare financial statement data with market data. Most notably this includes the PE ratio which compares the Share price of a stock with its earnings per share.
For a detailed description of all the ratios learnt in accounting 101 please purchase my E book.