Financial Ratio Analysis Offers Valuable Business Insights

A Powerful Financial Analysis Tool for Your Business

man doing calculations
••• aphrodite74/Vetta/Getty Images

Financial ratios are useful tools that help companies and investors analyze and compare relationships between different pieces of financial information across an individual company's history, an industry, or an entire business sector. Numbers taken from a company's income statement, balance sheet, and cash flow statement allow analysts to calculate several types of financial ratios for different kinds of business intelligence and information.

A Business Insight Tool

Financial ratio analysis can provide meaningful information on company performance to a firm's management as well as outside investors. Calculating the ratios is relatively easy; understanding and interpreting what they say about a company's financial status takes a bit more work. Ratios serve as a comparative tool of analysis for liquidity, profitability, debt, and asset management, among other categories—all useful areas of financial statement analysis.

Companies typically start with industry ratios and data from their own historical financial statements to establish a basis for ratio comparison. Analysts compare the ratios for a given firm to the ratios of other firms in the same industry and against previous quarters or years of historical data for the firm itself.

Performing an accurate financial ratio analysis and comparison helps companies gain insight into their financial position so that they can make necessary financial adjustments to enhance their financial performance.

Which Ratios Are Most Commonly Used?

When choosing which ratios to work with, companies use several standard ratios most often. These include the debt-to-asset ratio (total liabilities / total assets), working capital ratio (current assets / current liabilities), the quick ratio or acid test ((current assets – inventory) / liabilities), inventory turnover (cost of goods / average inventory) and for public companies, the price-to-earnings ratio (stock price/earnings per share), among others.

One ratio calculation doesn't offer much information on its own. For example, if a firm's debt-to-asset ratio for one time period (let's say a year) is 50 percent, that doesn't tell a useful story unless management compares it to previous periods, especially if the debt-to-asset ratio was only 25 percent historically. In this scenario, the debt-to-asset ratio shows that 50 percent of the firm's assets are financed by debt. An analyst wouldn't know if that is good or bad unless he compares it to the same ratio from previous company history or to the firm's competitors, for example.

Internal Company Trend Analysis

Established companies typically have several years' worth of balance sheet and income statement data to work with for ratio analysis. Calculating the financial ratios for several periods, whether quarterly or yearly, helps track useful trends in the company's operational performance.

External Industry Analysis

Just as important as internal trend analysis is industry analysis. It's useful to understand the average performance of a firm's industry over time as compared to the individual company. For example, if an industry's average ratios differ significantly from a firm's results, especially if they're better, company management would benefit from examining why and perhaps taking action to improve financial results.

Measuring Up Against Competitors

Companies also often compare their firm's ratios to competing firms. After gathering available ratio data from known competitors and similar firms in the same industry, analyzing a firm's performance in relation to its competitors can shed light on any competitive advantages, strengths or weaknesses the company may have and enhance its strategic planning.