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  Analysing and Interpreting Financial Statements Part I

Analysing and Interpreting Financial Statements Part I

Financial ratios

Financial ratios give a quick and comparatively simple means of assessing the financial health of a business. A ratio just relates one figure that appearing in the financial statements to some other figure appearing there (for instance, operating profit in relation to the amount invested in the business (capital employed)) or, maybe, to some resource of the business (for instance, sales revenue per square metre of selling space, operating profit per employee, and so on).

Ratios can be very useful while comparing the financial health of dissimilar businesses. Variations may present among businesses in the scale of operations. The meaning of this is that a direct comparison of, say, the operating profit produced through each business perhaps misleading. Through expressing operating profit in relation to some another measure (for instance, capital employed), the problem of scale is eliminated. A business along with an operating profit of, say, £10,000 and capital employed of £100,000 can be compared along with a much larger business along with an operating profit of, say, £80,000 and capital employed of £1,000,000 through the use of a simple ratio. Operating profit to capital employed ratio for the smaller business is 10 % (i.e. (10,000/100,000) × 100%) and similar ratio for the larger business is 8% (i.e., (80,000/1,000,000) × 100%). These ratios can be directly compared where comparison of the absolute operating profit figures would be much less meaningful. The requirement to eliminate variations in scale by the use of ratios can also apply while comparing the performance of similar business over time.

Through calculating a small number of ratios it is frequently possible to build up a good picture of the position and performance of a business. So it is not surprising that ratios are widely employed through those who have an interest in businesses and business performance. Even though ratios are not hard to calculate, they can be hard to interpret. It is significant to appreciate that they are actually only the starting point for additional analysis.

Ratios assist to emphasize the financial strengths and weaknesses of a business, but they cannot, by themselves, describe why those strengths or weaknesses present or why specific changes have take place. Only a comprehensive investigation will reveal these underlying reasons. Ratios tend to able us to know which questions to ask, than give the answers.

Ratios can be expressed in several forms, for instance like a percentage or as a proportion. The way that a specific ratio is available will rely on the needs of those who will employ the information. Even though it is feasible to compute a large number of ratios, only a few, based on main relationships, tend to be useful to a specific user. Several ratios that could be computed from the financial statements (for instance, rent payable in relation to current assets) might not be referred since there is no clear or meaningful relationship among the two items.

There is no usually accepted list of ratios that can be applied to the financial statements, nor is there a standard method of computing several ratios. Differences in both the choice of ratios and their calculation will be found in practice. Though, it is significant to be consistent in the way where ratios are computed for comparison aims. The ratios that we shall discuss here are those that are extensively used. They are well-liked because several consider them to be among the more significant for decision making purposes.

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