Evaluation of Company’s Health Using Financial Statements
An efficient method of analyzing a firm’s financial position and results as well as comparing different firms is through ratio analysis. In ratio analysis, the relationships between different pieces of financial information of a firm are used by financial analysts to look at a firm as a possible investment. Liquidity ratios measure the short-term solvency of a firm, while leverage ratios measure the long-term solvency of a firm. The asset management or turnover ratios measure how well a firm is using its assets to generate income and cash flow. Profitability ratios measure how efficiently a firm is managing its operations with respect to producing profits, and market value ratios measure a firm’s financial position and result compared with the market value of its stock.
For example, if the current assets of a firm are assumed at $ 2,500,000 and current liabilities at $ 1,250,000, then the current ratio of the company is obtained by current assets/current liabilities ($ 2,500, 000/$ 1,250,000) at 2; This implies that the company has a sound short-term liquidity position to meet its current liabilities. Similarly, the total debt ratio indicates the leverage position of the firm. Taking an example of total assets at $ 10,000,000 and total equity of $ 4,000,000 the total debt ratio is given by Total Assets-Total Equity/Total Assets (10,000,000 – 4,000,000/10,000,000 = 0.60 times or 60%). Thus the ratio analysis can be used to see how a firm has performed through changed periods and can also be used to compare the performance of other firms within the same industry.