Ratio analysis is a primary analytical technique that when used properly is an effective way to evaluate a company’s financial standing. A key to the proper execution of ratio analysis is the employment of a variety of ratios to give a balanced view of the company existence. These ratios include profitability, activity, liquidity and cash flow.
Ratios for Financial Statement Analysis
Profitability ratios measure a particular aspect of management’s operating efficiency. Three different ratios are used to evaluate management’s performance and help answer the following questions.
- How effective is management in employing assets profitably?
- How successful is management in maximizing the return on owners’ investments?
- How well has management done with the profit generated on sales?
Whereas profitability ratios determined management’s effectiveness in generating profit, activity ratios evaluate management’s effectiveness in using the profit/assets. To calculate an activity ratio, an asset is divided into the best measure of that asset’s activity. For example, for accounts receivable, the best measure of asset activity is sales.
The purpose of liquidity ratios is to determine the company’s ability to pay its short-term obligations. Two ratios are utilized to do so.
- Current ratio: The ratio defines the relationship between current assets and current liabilities.
- Quick or acid test ratio: This ratio is calculated like a current ratio except inventory is removed from current assets because inventory is usually not directly convertible to cash.
Cash Flow Ratios
The employment of cash flow ratios examine the adequacy of a company’s cash flows and the quality of its earnings. The cash flow ratio determines the extent to which cash flow from operations is enough for the company’s investing and financing activities.