Ratio Analysis Formulas

All financial statements are basically historical documents for history. They tell what happened during a period of time. However most users of financial statements are concerned about what will happen in the future. Shareholders are concerned with future profits and dividends. Creditors are concerned about the future ability of the company to repay its debts. Managers are concerned about the company's ability to finance its future expansion. Despite the fact that the financial statements are historical documents, they can still provide valuable information and direction on all these concerns.

Financial statement analysis involves a careful selection of financial statement data for the primary purpose of forecasting the financial health of the company. This is accomplished by examining trends in key financial data, the comparison of financial data between companies, and analyze key financial ratios.

Managers are also largely affected by the financial ratios. First, the rates provide indicators of how the company and its business units are in the scene. Some of these reports would normally be used in a Balanced Scorecard approach. The specific ratios selected will depend on the strategy of the company. For example, a company that wants to focus on responsiveness to clients can monitor the inventory turnover ratio. Since managers must report to shareholders and may wish to raise funds from external sources, managers must pay attention to financial ratios used by external inventories to assess the investment potential of the business and solvency.

Although the analysis of financial statements is a very useful tool, it has two limitations. These two restrictions imply the comparability of financial data between businesses and the need to look beyond the ratios. Comparing a company with another may provide valuable clues about the financial health of an organization. Unfortunately, differences in accounting methods between companies sometimes makes it difficult to compare data from financial companies. For example, if a company values its inventory using the LIFO method and another company by the average cost method, so direct comparisons of financial data such as stock assessments are and the cost of goods sold between the two companies can be misleading. Sometimes sufficient data are presented in the footnotes to financial statements to reprocess data on a comparable basis. Otherwise, the analyst must keep in mind the lack of comparability of data before drawing a final conclusion. However, even with this restriction in mind, the comparison of key ratios with other companies and with industry averages often suggest avenues for further investigation.

An inexperienced analyst may assume that the ratios are sufficient in themselves as a basis of assessment for the future. Nothing could be further from the truth. The conclusions based on ratio analysis must be considered provisional. Ratios should not be regarded as an end, but rather they should be considered a starting point, as indicators of what to pursue in greater depth. They can raise questions, but they rarely answer questions by themselves. In addition to reports, other sources of data must be analyzed to make judgments about the future of an organization. They must seek analyst, for example, industry trends, technological changes, changes in consumer tastes, changes in broad economic factors and changes within the company itself. A recent change in a key management position, for example, could provide a basis for optimism about the future, even if the past performance of the firm may have been poor.

Few figures on the financial statements are a far standing by themselves. It is the relationship of one figure to another and the amount and direction of change over time which are important in analyzing financial statements.