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Analysis of financial statements. Ratio Analysis

Category: Financial Risk Management

Introduction to Ratio Analysis

The principal method used to interpret financial accounts is Ratio Analysis, which is simply a means of highlighting, in arithmetic terms, the relationship between two figures in the accounts.

Generally, we do not look at ratios in isolation but, rather, at a trend over time or a comparison between a calculated ratio and an accepted norm for the particular industry.

Strengths and Weaknesses

Before we look in more detail at some of the more useful ratios calculated by the lending banker, it is important to stress that, while Ratio Analysis helps us assess risk, it is not an exact measure of that risk.

Next highlights some of the more obvious strengths and weaknesses of Ratio Analysis:

— Helps analysis of trends and meaningful comparisons

— Suggestions questions that need to be answered

— Balance Sheet figures may not be typical

— Figures not always objective

— Financial Analysis is not a comprehensive analysis of a business

Each of these points can be elaborated on:

Ratios are particularly useful in highlighting trends over a period of time. They facilitate comparison between different periods by eliminating the impact of volume changes. Also, they allow comparison with industry or sector norms.

Ratios cannot be used as an authority for making absolute statements. However, they suggest the questions that need to be asked, the answers to which will give us a more detailed knowledge of the business.

Balance Sheet figures reflect the position on a particular day, which may not be a typical one for a number of reasons e.g. seasonality, unusual transaction.

While there are reasonably strict rules for drawing up accounts, it is impossible to eliminate subjectivity e.g. value of premises, stock, bad debts etc.

Analysis of historical figures often tells us little or nothing about the current or future state of the business e.g. management ability, product quality, labour productivity etc.

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