How are financial ratios and trend analysis used to analyze and interpret financial statements? Which category (profitability, efficiency, liquidity, gearing, or investment) of ratios is most useful for company managers and why?
"Financial ratios can be very helpful when comparing the financial health of different businesses" (Atrill & McLaney, 2006). The percentage values calculated by the ratio equations remove the issue of scale from the comparison, and allow an analyst to see, for example, how an older IT leviathan like IBM compares to one of the IT industry upstarts such as Facebook. The ratios can also be used to show the performance of the same company over a period of time and indicate why it is succeeding (or failing). They are also used by analysts to compare the performance of similar companies in the same industry and show if a company is achieving the financial targets that it has set itself. The most common financial ratios can be largely divided into five categories; Profitability, Efficiency, Liquidity, Financial Gearing and Investment.
Trend analysis is extremely useful in understanding the performance of one or several businesses over a period of time. Plotting key financial ratios on a graph can quickly illustrate which companies are doing better than their rivals, what the general trends are, and even help to see into the future - very important when considering investment opportunities.
In answer to the second part of this question I would say that different management roles within a company will find different ratios useful. Speaking from personal experience of having worked on the shop floor of multinational wholesalers the most important ratio for the store manager was the profitability ratio. This could quickly inform him of any problem areas - for example, if the net profit of fresh food fell below a certain threshold then it was usually down to too much wastage, and he would be able to get his line managers to take corrective action - review what was being ordered or review stock rotation. In my current job in local government the profitability ratio has absolutely no relevance to the upper echelons of management. I would think that ensuring the financial viability of the Council - making sure that all its liabilities such as benefit payments and services are met. A report prepared by PriceWaterhouseCooper on the financial sustainability of local government in Australia stated that interest cover ratio, median sustainability ratio (which is capital expenditure / depreciation) and current ratio were important financial ratios in this particular industry which backs this theory up.
References:
Atrill, P. & McLaney, E. (2006) Accounting and Finance for Non - Specialists (5th Ed.) Essex, Pearson Education Ltd.
Pritchard, J. (2006) National Financial Sustainability Study of Local Government [Online] Canberra, Australian Local Government Association
Available from http://www.alga.asn.au/policy/finance/pwcreport/ (Accessed 20th Jan 2008)
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