What is Financial Ratio Analysis?

A Powerful Financial Analysis Tool for Your Firm

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Financial ratio analysis is a tool for investigating and comparing relationships between different pieces of financial information. You can use information from your company's income statement and balance sheet to calculate financial ratios.

A Valuable Tool

Financial ratio analysis can prove to be a valuable tool for your small business. First, you have to learn to calculate the ratios and understand what they mean.

They are a comparative tool of analysis for liquidity, profitability, debt, and asset management -- all major categories of financial ratio analysis.

You need to have industry ratios and/or time series data from your own firm for a basis of comparison. Then, you can compare the ratios for your firm to the ratios of other firms in your industry and other quarters or years of data for your firm.

If you do an accurate financial ratio analysis using comparative data, you can learn a lot about the financial position of your firm and make necessary financial adjustments to enhance your performance.

What Ratios Should Be Calculated?

There are any number of ratios you could calculate. When trying to decide which ratios to work on, there are some standard ones that most business firms use.

The problem with ratios is that they are useless unless they are compared to something. For example, if you calculate your firm's debt ratio for one time period (let's say a year) and it's 50%.

What does that really mean? All you can take from that is a debt ratio that shows total liabilities/total assets, and that 50% of your firm's assets are financed by debt. You don't know if that is good or bad unless you have something to compare.

Trend Analysis

Presumably, you have other years of balance sheet data for your small business.

It is very helpful if you calculate the financial ratios for several years (or quarters if you have that data) so you can track the trends in your ratio.

You can compare your firm's ratios to trend data. To complete this comparison, you want to take data from the past ( e.g. same time last year), and compare it to the present to see how your firm is doing over a series of time periods.

Industry Analysis

Just as important as trend analysis is industry analysis. It's very important, particularly in today's economic climate, to know what your industry is doing as compared to your company. For example, if your industry's ratios are much different than your firms, you want to examine why and perhaps take action.

You can also compare your firm's ratios to industry data. You can gather data from similar firms in the same industry, calculate their financial ratios, and see how your firm is doing in comparison to the industry at large. Ideally, to get a good financial picture of your firm, you should do both.

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