All of the stakeholders in a business will be interested in analyzing financial statements and the accompanying financial ratios derived from those statements. Utilizing financial ratios, business managers and owners can assess performance over the long-term and adapt to industry trends. Financial ratios indicate clearly show areas of strength, potential problems, and weaknesses, which managers can use in making decisions. Furthermore, managers and owners can review financial ratios to measure progress toward company goals. Investors, creditors, lenders, suppliers, customers, and employees understand the financial strength and growth potential of the company on the basis of financial statements and ratios.
By converting information from financial statements into ratios, stakeholders can compare companies of different sizes since the ratios themselves control for size. Nevertheless, financial ratios do have some drawbacks, including time sensitivity and the ability to misled when viewed in isolation.
Among the financial statements necessary for calculating financial ratios are the balance sheet and the income statement. The balance sheet displays a companys net worth through assets, liabilities, and owners equity during a defined time period (Ward, 2018).
Often, the balance sheet also includes details from previous years which allow comparisons in performance year over year. Additionally, the balance sheet assists owners and managers in planning so that financial obligations are met and credit is leveraged to best enable operations (Ward, 2018). Functionally, the balance sheet is a snapshot of a specific period, capturing all assets and debts, useful for determining convertible assets to cash, or liquidity, and the ability to use borrowed funds to produce profits, or financial leverage, of a company (Woodruff, 2018).
Also known as the profit and loss statement, the income statement demonstrates the net revenues and expenses of a specific time period. Since all companies exist to make a profit, the income statement is particularly useful for stakeholders to determine how well the company reached this goal. Managers and owners utilize the income statement to decide if objectives are being met or whether a change in course is needed to increase profits. Stakeholders can determine the financial health of a company by analyzing operating expenses, sales, and gross profit, which measures labor productivity and efficiency of materials consumptions (Woodruff, 2018).
Financial statements typically list data in the millions unless otherwise noted. Financial ratios establish the relationship between the revenue and expenses on the income statement to the assets, liabilities, and equity described on the balance sheet. From the balance sheet, the stakeholders can determine a companys liquidity using such measures as current and quick ratios. On the income statement, stakeholders can determine revenue, profits, and margins. During the fiscal year 2015, Wal-Marts balance sheet showed a net income of $16,363 which showed a slight increase from 2014 ($16,022) but did not exceed figures for 2013 ($16,099) and is indicative of the profitability of the company (Wal-Mart Annual Reports, 2015). This figure is calculated by subtracting expenses from total revenues.
One of the ways to translate financial statements into meaningful data is through financial ratios which convert the raw data of line items on the statements into measures that relate the data and present information on performance. Liquidity, solvency, and equity ratios help to present a fuller picture of the financial health of the company, long-term trends, and problem areas. Different stakeholders may value different ratios based on the financial information they deem most desirable.
The current ratio is a solvency ratio, measuring liquidity and efficiency by demonstrating the companys ability to pay off short-term liabilities, or those debts owed within the next year, by utilizing their current assets. GAAP require current and long-term liabilities to be entered separately on the balance sheet. Since the ratio measures current debt in terms of current assets, it is often expressed in the number of times a company can cover its obligations. For example, a current ratio of 4 means a company can cover its current obligations 4 times through its current assets. Typically, a higher current ratio is better because a company that has to used fixed assets to cover debt probably isnt making enough from its operations.
With the inventory turnover ratio, stakeholders can determine how well inventory is managed compared to the cost of goods sold. If inventory cannot be sold, it is worthless to the company. Creditors are often interested in this ratio because inventory is used as collateral.
With this liquidity ratio, the number of times receivables are turned over during the period is measured. In order to calculate average receivables, the amount of receivables at the beginning and end of the period are added and divided by 2. Typically, this ratio is compared to the industry standard, with a higher ratio indicating the company collects more efficiently.
As another profitability ratio, the return on assets measures how a company manages it assets to generate profits. Return on assets (ROA) is a measures the profit generated by each dollar invested in assets (Ross, Westerfield, Jaffe, & Jordan, 2016, p. 49). If prior year total assets are available, average total assets can be utilized in this calculation to control for asset fluctuation.
This ratio is a profitability ratio measuring net income earned per each dollar of sales. Both creditors and investors are interested in how well the company converts sales into net income. While investors want sales to be high enough to pay out dividends, creditors look for sales to generate enough income to cover debts.
This ratio is a liquidity ratio demonstrating the percentage of financing from creditors and investors. If this ratio is high, the company is using more bank loans than shareholder financing. A debt equity ratio of one shows the financing equally split, but a lower ratio generally indicates more stability financially.
Another solvency ratio, the quick ratio, measures the ability to pay current liabilities with quick assets, or those assets which can be converted to cash within 90 days (Ross et al., 2015). This financial acid test shows how quickly a company can turns assets into cash to pay its obligations. A higher quick ratio is usually better for the company.
In this ratio, sales are compared with the total assets of a company. One of the most useful ways to interpret this ratio involves plotting it on a trend line to easily spot changes over time. Industries that are more capital-intensive find this ratio more useful because higher turnover doesnt always mean higher profits, especially for service industries. Additionally, accumulated depreciation is included in this measurement and can skew results.
Financial statements provide key information concerning a companys overall financial health. Investors, managers, creditors, lenders, employees, and regulators examine these statements closely. Through the use of financial ratios, the relationships between key line items on financial statements, such as the balance sheet and income statement, can be diagnosed and evaluated. These evaluations help stakeholders make informed decisions and measure the success of a company in obtaining its number one objective, profitability.