In corporate finance, both ratio and financial statement analysis are important tools that can be used in order to assess a company’s strength financially. They can be used in order to forecast a business’ prospective cash flow and ability to grow in the future, as well as a company’s strengths and weaknesses. Income statements, balance sheets, the statement of retained earnings, and the statement of cash flows are the four primary types of financial statements used in corporate finance. All of these financial statements serve to analyze a firm’s cash flows from different perspectives and are all interrelated. Ratio analysis, another important tool in financial analysis, analyzes the probability that a firm will be profitable or not.
The different kinds of ratios used are liquidity ratios, efficiency ratios, leverage ratios, profitability ratios, and market-value indicators, with each type including various different specific ratios that one can calculate when examining a firm’s operability. Both the financial statements and ratio analysis offer an analysis of a firm’s finances at a particular point in time, while also forecasting its financial stability in the future. Another advantage is that they allow a firm’s finance team to compare its finances to that of other similar companies, known as benchmarks, in order to value the strength of their firm in the marketplace.
However, financial statements and ratio analysis can also lack in their accuracy since financial analysis is often based on historical figures from the past several years and thus only offer the prospective financial future rather than concrete data since often a firm’s finances are based on the ever-changing marketplace or other factors not in control of the firm’s managers, such as economic conditions. Despite such disadvantages, financial statements and ratio analysis is a very important aspect in the corporate environment and essential to examining a firm’s viability. Overview
In business, financial statements are important tools, which allow a firm to clearly state its financials in terms of figures, such as revenues, expenses, net incomes, etc. and analyze strengths and shortcomings of the firm. This allows the firm’s managers to clearly see what is and is not working for the firm. Ratio analysis is used when identifying and analyzing multiple variables in the firm’s operations, such as inventory, accounts receivable, net sales, etc.
When completing financial statement and ratio analysis, it is beneficial for the firm to examine its financial figures over several previous consecutive years, so that any and all patterns in its operability can be observed and analyzed. Such patterns can reveal aspects of the company where efficiency is not at its finest and thus there is a financial loss. As a result, the company can implement changes in order to improve upon these shortcomings and increase its profits. Ratio analysis is both a qualitative and quantitative way of looking at the data in order to analyze how a company functions and ways to improve it by looking at present and previous functioning and forecasting the future of the company.
Both financial statement and ratio analysis can provide insight into the success or failures of specific product lines, allowing managers to make intelligent decisions regarding what their firm should offer in the future to consumers. Financial statement analysis is also a way to assess and validate a company’s viability in the marketplace to outside investors/creditors. Financial statements assist managers in understanding how profitable their firm is. It is often used to make comparisons of one firm to another or of a specific time period to another time period for the same firm. The main aspects of a financial statement are revenues, expenses, and net income.
Revenues are sales numbers that come from products or services a firm creates through its business operations (Parrino, 2011). For a firm, such as Microsoft, its revenue would come from products such as the computers, phones, tablets, and software it sells to consumers. On the other hand, for a consulting firm, such as Accenture, revenues would stem from the fees it charges for its consulting services contracts with various government agencies around the world. Both companies are providing a product to a consumer, one simply happens to be a tangible product that people buy, while the other is a service product that agencies need for their functionality.
Expenses are the costs a firm incurs while generating its revenues (Parrino, 2011). For Microsoft, expenses would stem from the costs of building its products, marketing them, developing new products, shipping them around the world, etc. For Accenture, expenses would stem from the cost of all of its consultants, which includes their wages, insurance, company laptops it provides to each of them, travel costs for sending consultants around the world on projects, etc. Again both types of firms exhibit expenses; some of them are just different.
Net income shows the company’s revenue relative to its expenses. If revenues exceeds expenses then the company has a net profit and is “in the black” for that time period (Parrino, 2011). On the other hand, if expenses exceed revenues then the company has a net loss and is “in the red” for that time period (Parrino, 2011). By looking at financial statements from one fiscal period to the next or annually, managers can observe how their firm is progressing. If the numbers show that the firm is not operating at an optimal level or there is a sudden decline in profit, managers can delve further into the firm’s operations using ratio analysis to look for problem areas and address them accordingly.
For instance, ratio analysis can allow analysts to view the rate turnover of a specific product line and examine whether something is lacking in that product line that is hindering the firm’s ability to get rid of that inventory to consumers. Such ratio analysis will be elaborated upon later in this paper. There are four types of financial statements; income statements, balance sheets, the statement of retained earnings, and the statement of cash flows, which are all vital and interrelated. The income statement calculates the firm’s net income or its earnings after expenses have been deducted and is used to calculate retained earnings at the end of the year (Parrino, 2011). Net income is calculated as followed:
Net Income = Revenues – Expenses
The balance sheet summarizes what assets the firm has at a specific point in time, as well as how the firm has financed such assets (Parrino, 2011). Total assets is calculated as followed:
Total Assets = Total Liabilities + Total Stockholders’ Equity The value of assets will change annually since firms often buy and sell assets, thus altering the firm’s value and financing. Such changes are indicated in the statement of cash flows, which gives a summary of changes in the firm’s balance sheet from the beginning of a period to the end (Parrino, 2011).
The statement of retained earnings summarizes changes in the retained earnings in a simpler manner for managers than the statement of cash flows and basically shows the firm’s expenses and loss from one period to the next (Parrino, 2011). These financial statements can provide a lot of information to managers regarding the operations of the company. If Microsoft sees a decrease in its net income or total assets from one year to the next, this can indicate many things.
A decrease in net income can indicate maybe some products are not selling as well as they have in the past, meaning Microsoft may need to change its marketing strategy or release a new product. A decrease in total assets can mean several things. Perhaps the company’s products are of less value than before or perhaps they have fewer liabilities. Deciding what specifically financial statements mean for the future of a firm often requires more in depth analysis through ratio analysis.
Ratio analysis is the use of financial figures to analyze a firm’s overall operability and evaluate its strengths and weaknesses (Parrino, 2011). It can be used from various perspectives including stockholders, managers, and creditors, in order to evaluate the profitability of a firm. Specifically, a financial ratio is a “number from a financial statement that has been scaled by dividing by another financial number” in order to show something about the company’s operations (Parrino, 2011).
There are several types of financial ratios; liquidity ratios, efficiency ratios, leverage ratios, profitability ratios, and market-value indicators. Liquidity ratios focus on whether “a firm has the ability to convert current assets into cash quickly without loss of value” (Parrino, 2011). Two liquidity ratios are as followed:
Current Ratio = Current Assets / Current Liabilities
Quick Ratio = (Current Assets – Inventory) / Current Liabilities Liquidity ratios indicate a firm’s ability to pay short-term obligations, such as interest payments for debt. This is very important because every firm has creditors, whether its investors, banks, or even tax collectors and even the
most profitable company can go under if it is unable to pay all of its obligations for any reason. Efficiency ratios measure “how efficiently a firm uses its assets” and include the following:
Inventory Turnover = Cost of Goods Sold / Inventory
Days Sales in Inventory = 365 Days / Inventory Turnover
Accounts Receivable Turnover = Net Sales / Accounts Receivable
Days Sales Outstanding = 365 Days / Accounts Receivable Turnover
Total Asset Turnover = Net Sales / Total Assets
Fixed Asset Turnover = Net Sales / Net Fixed Assets
Efficiency ratios are a useful tool in financial analysis because they can examine and identify inefficient use of any kind of asset.
For instance, in our case of a decrease net income for Microsoft, financial analysts can look at the inventory turnover for each of its products and analyze whether one is too low indicating that the rate at which they are selling that specific product line is not efficient compared to the cost of producing that product line. Based on this managers can decide whether they should decrease the amount of inventory they produce or cut the product line all together. Leverage ratios are used to examine a firm’s financing or ability to meet long-term financial obligations. Leverage ratios are as followed:
Total Debt Ratio = Total Debt / Total Assets
Debt-to-Equity Ratio = Total Debt / Total Equity
Equity Multiplier = Total Assets / Total Equity
Leverage ratios are important because every firm uses debt or equity and often both for its financing, but the more debt a firm uses, the greater the risk it will default on those debt payments. So, for instance, the total debt ratio can tell you how much debt a firm uses in its capital structure and thus how volatile its earnings are (Parrino, 2011). Profitability ratios “measure management’s ability to efficiently use the firm’s assets to generate sales and manage the firm’s operations” (Parrino, 2011) and include the following:
Gross Profit Margin = (Net Sales – Cost of Goods Sold) / Net Sales
Operating Profit Margin = EBIT / Net Sales
Net Profit Margin = Net Income / Net Sales
Return on Assets(ROA) = Net Income / Total Assets
EBIT ROA = EBIT / Total Assets
Return on Equity(ROE) = Net Income / Total Equity
Profitability ratios are important because they indicate a company’s ability to be profitable relative to its expenses. Market-value indicators predict the future of a firm’s finances using market value trends and financial statements. They include:
Earnings Per Share(EPS) = Net Income / Shares Outstanding
Price-Earnings Ratio(P/E) = Price Per Share / Earnings Per Share
Market-to-Book Ratio = Market Value of Equity Per Share / Book Value of Equity per share
Market-value indicators are important because they can assist in predicting the future for a firm. Whether the firm will be profitable using its current strategy or should it maybe switch to a different strategy to keep up with competing companies. All of these financial ratios are crucial to financial analysis in corporations and used very often by analysts, managers, creditors, stockholders, etc. Advantages and Disadvantages of Ratio Analysis
Ratio analysis has several benefits. First, it offers various methods of analyzing a company’s financial wellbeing, going beyond just the financial statements by looking at specific aspects of operations. This can indicate strengths and shortcomings that managers should be aware of. Improvements can be made in order to increase profitability as a result. For instance, if a Microsoft notices that one product line has a higher days sales in inventory than another, this indicates that the specific product stays on the shelf longer and perhaps the firm should focus more on the product line with the lower days sales in inventory as it sells better.
Secondly, ratio analysis can assist in predicting earnings or showing a pattern, which managers can use to find the best way to maintain financial profitability. While financial statements provide numbers such as revenues or expenses, ratio analysis can offer a concrete number describing revenues relative to the cost of the goods sold, such as with the gross profit margin. Such a ratio can indicate how profitable a firm’s operations were in a specific period of time and if very profitable a concrete method of recreating such success.
Essentially, ratio analysis simplifies the information provided in financial statements by compartmentalizing them to show patters and trends, which are very useful. Thirdly, ratio analysis can also be used in order to compare the firm’s operations to that of its competitors. Often, how well a company is doing depends on the market and how well other companies are doing, so ratio analysis provides a very useful tool to companies in making such comparisons.
There are some disadvantages to ratio analysis. Predictions based on ratio analysis can be inaccurate from time to time. This is because ratio analysis is mostly based on historical data from previous time periods, which only offers so much information about the future. Yes, analysts can predict that the market will behave a certain way through market value indicators, but such predictions are only so accurate.
The market can be affected by a variety of aspects, such as volatile economic conditions or even a natural disaster. For example following Hurricane Katrina, at “the end of the first week following…U.S. commercial crude oil inventories fell by 6.4 million barrels from the previous week,” indicating a strong market effect on petroleum due to the disaster (“Hurricane Katrina’s impact,” 2011). Businesses cannot control environmental disasters or economic conditions, which is why while ratio analysis is a very useful tool, it cannot always be relied on 100%. The use of market-value indicators is increasingly used in order to better forecast the future of a firm as it takes into account the economic climate at a specific point in time in order to predict the trend of future financial entities (Niazi, 2011) but again sometimes something like a natural disaster can negatively affect business.
This is why having a high operating income and total assets is important to be prepared for such events. While not a perfect model as random economic turbulence can skew results, market-value indicators do still provide some insight into the future. Furthermore, when using ratio analysis to compare to another similar benchmark firm, there can also be pitfalls. Often it is impossible to find a company similar enough in size, corporate structure, and operations to properly compare to and gauge a market comparison. Thus, often ratio analysis when benchmarking can provide a skewed impression of where the firm
stands against its competitors in the market.
Financial statement and ratio analysis are very useful in corporate finance that provide much information to analysts, managers, stockholders, and creditors about the financial state of a firm. While there are some shortcomings to ratio analysis, its advantages in practice surely outweigh its disadvantages and offer valuable tools to cultivate a thriving company.
Hurricane Katrina’s impact on the U.S. oil and natural gas markets. (2011, September 12). Retrieved from http://www.eia.gov/oog/special/eia1_katrina_091205.html
Niazi, G. S. K., Hunjra, A. I., Rashid , M., Akbar, S. W., & Akhtar, M. N. (2011). Practices of working capital policy and performance assessment financial ratios and their relationship with organization performance. World Applied Sciences Journal, 12(11), 1967-1973.
Parino, R., Kidwell, D. S. & Bates, T. W. (2012). Fundamentals of Corporate Finance: Second edition. John Wiley & Sons; Hoboken, NJ.