Financial Ratio Analysis

Balance Sheet: A document describing the finanical position of a company at a particular point in time. It compares the value of items owned by the company (its assets) with the amounts that it owes (liabilities)

Assets: Items that are owned by an organisation

Non-current assets: Resources that can be used repeatedly in the production process, although they do wear out (depreceate) or lose value over time. These are often known as fixed assets

Current assets: short-term items that circulate in a business on a daily basis and can be expected to be turned into cash within one year

Liabilities: debts owed by an organisation to suppliers, shareholders, investors or customers who have paid in advance

Total equity or total shareholders' equity (capital): Funds provided by shareholders to set up the business fund expansion and purchase fixed assets

Income statement: An account showing the income and expenditure (and thus the profit or loss) of a company over a period of time (usually a year)

Purpose of the income statement:

• regular calculations of profit throughout the year help managers to review progress before the final end-of-year accounts are completed, while the final accounts allow managers to assess the success of their policies
• it allows the shareholders to assess whether their investment is beneficial
• It enables people to see if profit is being utilised in a sensible way
• To satisfy legal requirements, the Companies Act requires companies to publish their income statements
• Publication allows stakeholders to see if a firm is meeting their needs
• Comparisons can be made over time (temporal comparisons) to see if a firm is improving its performance
• Comparisons can be made within the business (intra-firm comparisons) to assess the effectiveness of different divisions or branches
• The income statement can be used to show potential investors that a firm is successful and able to repay loans or provide a good return on investments

Gross profit: revenue minus cost of sales. Shows how efficiently a business is converting its raw materials or stock into finished products

Operating profit: the revenue earned from everyday trading activities minus the costs involved in carrying out those activities

• Inter-firm comparisons - comparisons with other businesses
• Comparisons over time - trend analysis
• Intra-firm comparisons - comparisons within the business
• Comparisons to a standard

Ratio Analysis definition: a method of assessing a firm's financial situation by comparing two sets of linked data

Type of ratio:

• Profitability ratios
• Liquidity ratios
• Gearing
• Financial efficiency ratios