Question

What is the importance of analyzing Financial Statements through Ratio Analysis, Explain and use examples of specific ratios. (Should be 250 words minimum)

Answer 1

Ratio Analysis –

Every company in the world is unique not just in terms of its business and style of doing business but also in the size and scale of its financials. Even two companies working in the same sector and catering to same set of customers will have different revenues, profits, assets and liabilities. So, comparing two companies by using absolute numbers from the P&L statement or balance sheet is not possible.

In such a scenario ratio analysis gives us chance to compare different companies by using the ratio of 2 or combination of more than 2 absolute numbers from the financial statements of the companies.

Depending upon the type of analysis is required by an analyst or investor, type of ratio utilized also varies. Some examples for the financial ratios are given below –

Eg. 1 : Net Profitability = Net Income/Total Sales(Revenue)

As the name suggests, this ratio gives the profitability of the company in terms of how much the companies is able to save from its revenues after carrying out all the expenses. Suppose a company A has revenue of $100, with net profit of $10, whereas a smaller company of $20, but a net profit of $5. In absolute terms company A sounds more profitable but using Net Profitability ratio, A has a profitability of 10% but company B has a profitability of 25%. So, scale of operations is smaller for company B, but has a significantly higher profitability that company A.

Eg. 2 : Current Ratio = Current Assets/Current Liabilities

Current ratio depicts the liquidity position of a company. Although some experts consider current ratio of 2 as a good value, but there is no perfect value for this ratio and value changes for companies belonging to different sectors. A very small Current Ratio shows that current assets are very small as compared to current liabilities. Or current liabilities are very high, that indicates a liquidity crunch situation for the company. Very high current ratio may also not be considered very good. This means company has a very high Current Assets, if these are all coming from the “debtors”, default from the debtors might land company in a very poor situation. Hence, optimal Current Ratio must be maintained by the company.

Eg. 3 : PE (Price to Earning) Ratio = Price of the stock in the market/ Earning Per Share

This ratio is utilized by the investors to find out if a company is overvalued or undervalued as compared to its peers in the market. As all the factors affecting the companies in the same domain remain same, expected return by the investor in the same domain also remains same. In such a case, fair price of a stock is directly proportional to the Earning of the company. A high PE Ratio depicts that the company is overvalued and stock must be sold, whereas a low EPS shows that the company is undervalued and must be purchased.

But no ratio can be seen in isolation, while performing the ratio analysis different ratios are utilized to paint a complete picture on the health of the company. Depending upon the need of the analyst suitable set of ratios must be chose for doing the analysis.