Ratio and Financial Statement Analysis

RATIO AND FINANCIAL STATEMENT ANALYSIS

Myron Davis

Financial Decision Making for Managers

July 16, 2017

Executive Summary

The purpose of this paper is to introduce and analyze the benefits and limitations of financial statement and ratio analysis. Financial Statement ratios and ratio analysis are useful because it allows the user to compare ratios to previous periods and industry averages to determine if a company is performing up to expectations. There are four general categories of financial ratios include liquidity ratios, activity ratios, leverage ratios, and profitability ratios. Financial ratio analysis is a tool that has many benefits but also a few limitations. The four main benefits as listed by David Ingram of smallbusiness.chron.com are comparison, industry analysis, stock valuation, and planning and performance. The four limitations as listed by accountingtools.com article are historical results, inflation, diversification, and accounting policies. Overall financial statement ratios can be a very powerful tool that can be beneficial for any business and its other users if they account for the limitations associated with the ratios. As long as businesses are operating I believe the financial statement analysis and financial ratios will continue to be great tools that I see being used for the rest of time.

Introduction of Ratio and Financial Statement Analysis

The financial statement analysis of a business is arguably the most important analysis in determining the financial health of a business. Investopedia.com defines financial statement analysis as “the process of reviewing and evaluating a company’s financial statements, thereby gaining an understanding of the financial health of the company and enabling more effective decision making.” (Investopedia, 2017). The analysis involves identifying two items in a company’s financial statement trends and proportional analysis. Accountingtools.com defines trends as “trend lines for key items in the financial statements over multiple time periods, to see how the company is performing. Typical trend lines are for revenues, the gross margin, net profits, cash, accounts receivable, and debt.” (Accountingtools, 2017). It also defines proportion analysis as “An array of ratios is available for discerning the relationship between the size of various accounts in the financial statements.” (Accountingtools,2017). Financial Statement analysis has been described as the most important financial analysis because of the individuals that use the analysis. There are several users of financial statement analysis but the main four are creditors, investors, management, and regulatory authorities. Creditors use the analysis’ cash flow measures to determine the ability of its lender to pay back the debt. Investors both current and prospective use the analysis to learn about a company’s ability to continue issuing dividends and generate cash. Management uses the analysis in relation to determining operational metrics that are not seen by the outside entities including cost per delivery, cost per distribution channel, profit by product, etc. Regulatory authorities such as the SEC (Securities and Exchange Commission) use the analysis to determine if the statements of a company conform to the various accounting standards and rules of the SEC.