Financial Ratio Analysis

Madiha Batool Zaidi

Finance Test

Executive - Content Development

Section A

Topic: Financial Ratio Analysis

* What is financial ratio analysis?

As a manager you may want to reward employees based on their performance. How do you know how well they have done? How can you determine which departments have performed well? As a lender, how will you decide the borrower will be able to pay back as promised? As an investor, how do you predict how well the securities of one company will perform relative to that of another? How can you tell whether one security is riskier than another? We can address all of these questions through financial analysis.

Financial analysis is the selection, evaluation and interpretation of financial data and other relevant information, to assist in investment and financial decision-making. Financial analysis may be used internally to assess employee performance, the efficiency of operations and credit policies and externally to evaluate potential investments and the credit-worthiness of borrowers.

The analyst draws the financial data needed in financial analysis from many sources. The primary source is the data provided by the company itself in its annual report which comprises the Income Statement, The Balance Sheet, The Cash flow Statement and the notes to financial statements and required disclosures. Besides information that companies are required to disclose through financial statements, other information is readily available for financial analysis. For example, information such as the market prices of securities of publicly listed companies can be found in the financial press and newspapers.

Another source of information is economic data, such as Gross Domestic Product or Consumer Price Index, which may be useful in assessing the recent performance or future prospects of a company or industry. Suppose you are evaluating a company that owns chain retail outlets. What information do you need to judge the company's performance and financial condition? You need financial data, but it doesn't tell the whole story. You also need information on consumer spending, producer prices, consumer prices and the competition. This is economic data that is readily available from government and private sources.

Besides financial statement data, market data and economic data in financial analysis you also need to examine events that may help explain the company's present condition and may have a bearing on its future prospects. For example, did the company recently incur some extraordinary losses? Is the company developing a new product? Or acquiring another company? Is the company regulated? Current events can provide information