Financial Ratio AnalysisFinancial ratio analysis is useful when you want to compare the financial performance of one or more businesses. This is achieved by performing some computations that use standard accounting formulas, and hence monitor their relative strengths and weaknesses over time. It sounds more complicated than it is. There is a well known saying in investment circles: “you only start to understand the accounts of a company after you've made at least one calculation from the numbers presented to you..” What is a Financial Ratio?A financial ratio is simply one number divided by another, and expresses the value of the first item in the relationship in terms of the second. For example to compute the average number of days it takes a business to collect what is owed from customers who took credit at the time of sale, divide the trade debtors value in the balance sheet by the turnover reported in the income statement and multiply by the number of days in a year. This tells you how long it takes customer (on average) to pay what they owe. Trade Debtors / Turnover x 365 = Average Debtor Days $103,799 / $578,996 x 365 = 65.4 Average debtor days. It is surprising when you do this for a number of different businesses how long those debts can take to collect! Financial Ratio UsesIf you think about what you might want to learn about the nature of a company (including your own business), then after a bit of brainstorming you might come up with this.
If you use ratio analysis to measure, and answer these questions regularly, you can see how the impact of any initiatives you implement affect performance. Put it another way. What you can’t measure, you can’t move! Depending on your stakeholder relationship with the business in question, you may need to answer more specific questions than asked above - questions aligned to your interest in the business concerned. For example: As a supplier you may wish to know about the strength of the company with a view to setting a credit limit and payment terms. As an investor you may want to secure an idea about the likely rate of return on your investment. You may also want to compare the likely return from investing in one company with another. This is where financial ratio analysis comes in. Financial Ratio Health WarningWhile Financial Ratio analysis can help you benchmark your chosen business performance against a competitor in the same industry, beware that no two business are entirely identical so you have to have your wits about you when making these comparisons. Don’t just follow the numbers blindly. Ratio analysis is split into the following key areas.
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