If your accounting is not a real representation of your business, it is like giving blood or urine of another person to the lab to be analyzed; the results will not give you any correct prognostic about the health of your business.
The following are some of the analysis that can be done to learn how effective and efficient is your business and to help you in making decisions about your business.
A popular way to analyze the financial statements is by computing ratios. A ratio is a relationship between two numbers, e.g. ratio of A: B = 1.5:1 ==>
A is 1.5 times B. A ratio by itself may have no meaning. Hence, a given ratio is compared to:
• Ratios from previous years for internal trends
• Ratios of other firms in the same industry for external trends
Ratio analysis is a diagnostic tool that helps to identify problem areas and opportunities within a company.
The most frequently used ratios by Financial Analysts provide insights into a firm's
• Liquidity
• Degree of financial leverage or debt
• Profitability
• Efficiency
• Value
A. Analyzing Liquidity
Liquid assets are those that can be converted into cash quickly. High liquidity means that the company will not default on its short-term obligations.
1. Current Ratio
2. Quick Ratio
B. Analyzing Debt
Debt ratios show the extent to which a firm is relying on debt to finance its investments and operations, and how well it can manage the debt obligation.
1. Leverage Ratios
1a. Debt to Equity Ratio
1b. Debt to Assets Ratio
2. Interest Coverage (or Times Interest Earned) Ratio
3. Cash Flow Coverage
4. Net cash flow
C. Analyzing Profitability
Profitability is a relative term. It is hard to say what percentage of profits represents a profitable firm, as profits depend on such factors as the position of the company and its products on the competitive life cycle (for example profits will be lower in the initial years when investment is high), on competitive conditions in the industry, and on borrowing costs. 1. Net Profit Margin
2. Return on Assets (ROA)
3. Return on Equity (ROE)
4. Earnings per Common share (EPS)
5. Payout Ratio
D. Analyzing Efficiency
These ratios reflect how well the firm's assets are being managed. The inventory ratios shows how fast the inventory is being produced and sold. 1. Inventory Turnover
2. Total Assets Turnover
3. Accounts Receivable Turnover
4. Average Collection period
5. Days in Inventory
E. Value Ratios
Value ratios show the “embedded value” in stocks, and are used by investors as a screening device before making investments. 1. Price To Earnings Ratio (P/E)
2. Dividend Yield
