Financial ratio analysis is one tool of investigating and comparing relationships between different pieces of financial information. You use information from the income statement and balance sheet to calculate financial ratios in order to determine information about your small business firm. There are any number of ratios you could calculate. To solve that problem, there are some standard ratios that most business firms use.
The problem with ratios is that they are useless unless they are compared to something. For example, if you calculate your firm's debt ratio for one time period (let's say a year) and it's 50%. What does that really mean? All you can take from that is that, since the debt ratio is Total Liabilities/Total Assets, 50% of your firm's assets are financed by debt. You don't know if that is good or bad unless you have something to compare that 50% to.
Trend and Industry Analysis
That's where trend (time-series) and industry (cross-sectional) analysis come in. You can compare your firm's ratios to trend data, which is data from other time periods for your firm, to see how your firm is doing over a series of time periods.
You can also compare your firm's ratios to industry data. You can gather data from similar firms in the same industry, calculate their financial ratios, and see how your firm is doing compared to the industry at large. Ideally, to get a good picture of the financial picture of your firm, you should do both.
Articles and Resources to Help You
Here are some articles, FAQs, and resources to help you complete financial ratio analysis for your business.
- What is financial ratio analysis and how is it used?
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This is the introductory FAQ on financial ratio analysis.
- Trend and Industry Analysis
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Ratios are meaningless without trend or industry data to compare them to. Compare your firm's ratios to industry averages or other time periods of data from within your firm.
- What are the five categories of financial ratios and what does each measure?
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There are five categories of financial ratios and each measures a particular metric valuable to your firm.
- FAQ on the Liquidity Ratios
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This is the introduction to the FAQ on liquidity ratio analysis.
- Tutorial: A Beginning Analysis of a Company's Liquidity Position Using Financial Ratio Analysis
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This is a step-by-step beginning tutorial on how to analyze a company's liquidity using the current and quick ratios along with net working capital.
- FAQ on the Debt Ratios
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This is the introduction to the FAQ on debt or financial leverage ratio analysis.
- Tutorial on Debt Management Ratio Analysis
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This is a tutorial on debt management using financial ratio analysis.
- FAQ on Asset Management Ratios
This is the introduction to the FAQ on the asset management or asset utilization (turnover) ratios.
This is an article on asset management or efficiency ratios. All the relevant asset management ratios are explained and calculated.
This is a calculation and explanation of all the most often used profitability ratios.