An overview of Ratio analysis and other financial tools
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- 1 An overview of Ratio analysis and other financial tools
All financial analysis starts with Ratio analysis. Ratio Analysis is a tool to combine two pieces of financial data. It establishes a relationship between them. It detects a trend. Also, it creates a relative ranking.
It is a powerful financial tool. It analyses various metrics across a firm's history. We can also analyse the industry sector by comparing peer companies. A firm can use that information from financial ratio analysis. Find the relative positions of companies in the market.
Types of ratio analysis
We use different types of ratio analysis to examine different metrics
Solvency ratios look at the debt/equity ratio. It also looks total debt to total assets ratio.
Liquidity ratios look at the working capital, cash, and quick ratios.
Profitability includes net interest margin and EBIT/total assets. We also analyse return on total assets and return on equity.
Efficiency ratios look at different turnover ratios. Inventory turnover, day's sales outstanding, fixed assets and total asset turnover ratios are some of the ratios.
Coverage ratios look at the interest earned and debt service coverage ratio.
Market prospects include ratios such as earnings per share and price-earnings ratio. We also analyse the price-to-cash flow ratio and price/book value per share. We also examine return ratios like dividend yield and dividend payout ratios.
Uses of ratio analysis
Companies use ratio analysis for the following purposes:
Making inter-firm comparisons:
Firms use ratio analysis to compare their financial performance with other firms in the industry. They calculate the ratios of the financial performance measures. This helps companies to make inter-firm comparisons. We analyse the performance and establish relative rankings.
Making such comparisons with known competitors enables a company to do a SWOT analysis. We establish areas of strengths, weaknesses, opportunities and threats. The firm can use this information to strengthen its relative market position.
In this, firms establish trends and detect performance patterns. For this purpose, we collect data from different periods of reporting. The data obtainpredictsict future trends in demand, costs, and market prices. We forecast future uptrends and downtrends to plan accordingly. Our future business decisions depend on our understanding and forecasting of these trends.
The various cost behaviour patterns and their relationship with sales enable companies to identify problem areas. The firm then executes control measures to manage the costs. This way, they can eliminate the inefficient use of assets and resources.
Benefits of financial ratio analysis
Financial Ratio analysis helps us to understand and interpret financial statements. It helps firms to strengthen the firm's balance sheets. Just a regular examination does not reveal this data. Ratio analysis, however, is not forward-looking. It uses historical information to analyse the company's performance.
Other Financial tools
Cash flow analysis and trend analysis are other financial tools used apart from ratio analysis.
Cash flow analysis
We look at the firm's incoming and outgoing cash flows in cash flow analysis. It enables firms to know the availability of cash. We ensure the smooth running of the company's operations and transactions. Cash flow transactions are classified into:
1) Operating activities
2) Financing activities
3) Investing activities
Cash flow analysis and forecast are used to assess new project viability. Firms use financial measures like Net Present Value, Internal rate of return, and holding period return to measure the economic viability of a project. We factor trend analysis into cash flow analysis to make accurate forecasts for the future.
We use trend analysis of historical data to predict future demand and market price trends. We analyse uptrends, downtrends and sideways trends.
Technical analysis is a trend analysis method which uses historical stock prices. This helps make predictive patterns about future price movements.
In financial sales and cost analysis, firms predict future forecasts using trend analysis. This tool is specially used while building financial models. First, we do demand forecasting. Then, we analyse the relationship between sales and costs to forecast future prices. Trend analysis helps us detect regional, area, or even product and brand sales increases.
Benchmarking is another tool we use to compare performance to management targets. We set such targets for various financial parameters. Companies use this tool for optimising consumer-focused activities. They also reduce other internal organisation costs.
Want to learn ratio analysis?
Imarticus Learning, with its ratio analysis course, offers a Financial Analysis Prodegree in collaboration with KPMG in India.
In this Financial Analysis training, one can learn about all aspects of ratio analysis and learn financial analysis using other tools. Candidates can get an in-depth insight into all the core functions of Finance in this 180-hour course. The curriculum includes Accounting and Financial Modelling, Valuation and Corporate Strategy and Equity Research, M&A, Job Readiness etc.
Visit Imarticus learning to learn more about this Financial Analysis Pro degree. Contact us through chat support, or drive to our training centres in Mumbai, Thane, Pune, Chennai, Bengaluru, Delhi, Gurgaon, or Ahmedabad.