Menu

Chapter 8: Basic Financial Analysis

08-Financial-Analysis
Accounting

Financial analysis involves reviewing and interpreting a company’s financial data—often by calculating ratios—to assess its overall performance and health. These insights guide strategic decisions and help stakeholders understand where the business stands and where it could go next.

  1. Reading Ratios (Liquidity, Profitability, etc.)

Liquidity Ratios

  • Definition: Measure a company’s ability to meet short-term obligations (pay bills, salaries, etc.).
  • Examples:
    1. Current Ratio = Current Assets / Current Liabilities
      • Values above 1.0 suggest that a company can cover its short-term debts with current assets.
    2. Quick Ratio (Acid Test) = (Current Assets – Inventory) / Current Liabilities
      • Excludes inventory to focus on the most liquid assets (cash, receivables).

Profitability Ratios

  • Definition: Examine how effectively a company generates profit relative to sales, assets, or equity.
  • Examples:
    1. Gross Profit Margin = (Revenue – Cost of Goods Sold) / Revenue
      • Shows the percentage of revenue left after covering direct costs of production or service delivery.
    2. Net Profit Margin = Net Income / Revenue
      • Reflects overall profitability after all expenses, taxes, and interest.
    3. Return on Assets (ROA) = Net Income / Average Total Assets
      • Indicates how efficiently a company uses its assets to generate profits.
    4. Return on Equity (ROE) = Net Income / Average Shareholders’ Equity
      • Measures how effectively the company uses shareholders’ funds to generate returns.

Other Useful Ratios

  • Debt-to-Equity (D/E) = Total Liabilities / Shareholders’ Equity
    • Shows how much of the company’s operations are financed by debt versus equity.
  • Inventory Turnover = Cost of Goods Sold / Average Inventory
    • Reveals how quickly a company sells through its inventory, helpful for retail and manufacturing.
  1. How Analysis Helps Decision-Making
  1. Identifying Strengths and Weaknesses
    • Ratios highlight areas of efficiency (like high profitability margins) or areas of concern (like slow inventory turnover).
    • This insight helps management allocate resources to bolster underperforming segments.
  2. Benchmarking and Goal Setting
    • Comparing ratios with industry benchmarks or past performance reveals whether you’re keeping pace with competitors or improving over time.
    • Establishing target ratios (e.g., a Current Ratio of 1.5) gives your team clear objectives.
  3. Risk Assessment and Creditworthiness
    • Creditors and investors look at ratios (like Debt-to-Equity) to gauge the risk of lending money or buying shares.
    • A strong liquidity profile suggests you can handle unforeseen expenses or short-term downturns without defaulting on obligations.
  4. Pricing, Cost Management, and Expansion
    • A high cost ratio (low profit margin) might prompt cost-reduction strategies or changes in pricing.
    • A solid Return on Assets might indicate the business can expand comfortably without overextending resources.
  5. Informed Strategic Decisions
    • Financial analysis supports decisions about new product launches, market expansions, or capital investments by projecting potential returns and risks.

Key Takeaway

Financial ratios distill complex numbers into actionable insights. By measuring liquidity, profitability, leverage, and other factors, you can pinpoint strengths, address weaknesses, and steer your business toward sustainable growth. In turn, these analyses enable better strategic planning, risk management, and communication with investors and lenders.