Ratio Analysis: Understanding Financial Performance

This document provides an overview of accounting ratios and their significance in evaluating a company's financial performance. It explains different types of ratios, such as working capital ratio, current ratio, quick ratio, cash flow liquidity ratio, accounts receivable turnover, and debt ratio. The document also discusses the use of ratios in comparing companies and industries, as well as trend analysis methods like vertical and horizontal analysis.

Running head: RATIO ANALYSIS 1
Ratios Analysis
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Financial Ratios
Accounting ratios are a group of metrics utilized when determining whether a
company is efficient or profitable based on the financial reports (Goldman, 2017). The ratios
are generated by accountants by comparing two-line items in the company’s financial
statement; these items are the P&L account, the statement of cash flow, and the BS statement.
Essentially, one accounting ratio cannot be useful by itself as proper analysis of the different
ratios is critical for any organisation. Some of the ratios include;
 Working capital ratio-it is a liquidity ratio that measuring a businesses’ capability to
settle short-term obligations using its short-term assets.
 Current ratio- This ratio measures the businesses’ chances of meeting its short-term
obligations. The businesses’ short-term assets are compared to its short-term
obligations (Goldman, 2017). It indicates a firm liquidity
 Quick ratio/Acid test ratio -it is the test immediate cash and cash equivalence to pay
off debts. It measures a firm’s capability to settle its short-term obligations
immediately with only quick assets (Wong and Joshi, 2015). Quick assets are any
companies’ assets convertible to cash within a short period normally within 90 days.
 Cash flow liquidity ratio-this is a ratio used when comparing cash flow to a
company’s market value. Cash flow liquidity ratio is a measure of a firm’s cash and
cash balances in the short term.
 Accounts receivable turnover-It is an evaluation of a businesses’ capacity to provide
credit facilities to its customers and collect funds in time.
 Debt ratio- is regarded to be a measure of a company’s leverage that is the
percentage of the total assets of the business to debts.
Within organisations ratios are used to highlight positive aspects of a company while
also highlighting problems. Complex financial data and accounting statements are also

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simplified, improving efficiency (Chiaramonte and Casu, 2017). Ratios are also used when
conducting comparisons with other organisations, intra firm comparisons, and industry
standards this aids in understanding the financial position of an organisation in the industry.
An effective system of calculating ratios and trend analysis work is through the preparation of
the horizontal and vertical analysis of the statement of income.

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Ratio Analysis Memo
To: Co-worker
From: Me
Date: 28/05/2019
Accounting Ratios
A financial or accounting ratio involves the selection of two numerical values from
the financial statements. Many ratios are normally useful in evaluation of the financial
position of an organisation; the ratios are used by the management, creditors, and
shareholders (Durrah, Rahman, Jamil and Ghafeer, 2016). Ratios are an important part of
financial analysis since they quantify the business aspects, they also enables comparison
between firms, industries. Ratios can be utilized to assess performance of one firm over time
and its performance as compared to similar businesses in the industry.
Ratios like earnings per share are useless on their own. They are important when
compared alongside something else such as previous performance and a different firm. Ratios
are also critical when evaluating the viability of a potential investment. As the results are
compared to other firms, through the ratio analysis, the management is able to disapprove or
validate a firm’s investment, financial decisions, and operating decisions. This makes the use
of ratios more preferred than using dollars for evaluation decision making. (Christensen,
Nikolaev, & Wittenberg, 2016).
Vertical and horizontal analysis are the two types of trend analysis widely used.
Vertical analysis is used to express amounts as a percentage in the financial statement of
another firm in the same industry. Horizontal analysis also known as trend analysis compares
ratios from the financial statements of the same firm over some years (Wong and Joshi,
2015). These methods are used to assess the company’s performances and examining a
company’s financial statement. Based on the relevance of this aspect, we can learn that

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evaluation of the key items provides fundamental information about a company’s
performance over a fiscal year.

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References
Chiaramonte, L., & Casu, B., (2017). Capital and liquidity ratios and financial distress.
Evidence from the European banking industry. The British Accounting Review, 49(2),
138-161.
Christensen, H. B., Nikolaev, V. V., & Wittenberg‐Moerman, R. (2016). Accounting
information in financial contracting: The incomplete contract theory perspective.
Journal of accounting research, 54(2), 397-435.
Durrah, O., Rahman, A. A. A., Jamil, S. A., & Ghafeer, N. A. (2016). Exploring the
relationship between liquidity ratios and indicators of financial performance: An
analytical study on food industrial companies listed in Amman Bursa. International
Journal of Economics and Financial Issues, 6(2), 435-441.
Goldmann, K., (2017). Financial liquidity and profitability management in practice of polish
business. In the Financial Environment and Business Development (pp. 103-112).
Springer, Cham.
Wong, K., & Joshi, M., (2015). The impact of lease capitalisation on financial statements and
key ratios: Evidence from Australia. Australasian Accounting, Business and Finance
Journal, 9(3), 27-44.