A single item from a financial statement has only limited meaning until it is related to some other item. For example, the current assets of 10, 000 $ mean one thing when current liabilities are 5, 5000 $, and another when they are 50, 000 $.
For this reason, ratios have been developed to relate different income statement items to each other, different balance sheet items to each other, and income statement items to balance sheet items.
Analysis of financial statements
Although numerous financial statement ratios can be computed, only those that are the most practical and widely used for small businesses will be explained here.
These ratios will be grouped according to the symptoms of impending business failure discussed, using the financial statements of the Parker Manufacturing Company for illustrative purposes. It must be emphasized that a careful interpretation of ratios is required to make them useful to a particular firm.
A ratio may indicate potential trouble, but it cannot explain either the causes or the seriousness of the situation. Most small firms find it profitable to compare their ratios with their own experience and with industry-standard ratios.
Selected Key Ratios in Financial Analysis
Some key ratios ascertained from records obtainable from accounts are of valuable help to the small rosiness owners/ management. These are:
Figure showing the test of profitability and financial health of a small business
The use of ratios for small business decisions may be hinted from the table provided: We have furnished the name of the ratio with its formula, measures, and indications.
These speak about owners’ return possibilities, liquidity, leverage, debt serviceability, and the like. The selected ratios are:
| Ratio | Formula | What it Measures | What it Tells You |
| Owner’s Return on investment (ROI) | Net Income Average Owner’s Equity | Return on the owner’s capital; when compared with the return on assets, measures the extent financial leverage is being used for or against the owner. | How well is this company doing as an investment? |
| Return on Assets (ROA) | Net Income Average Total Assets | How well assets have been employed by management | How well has management employed company assets? Does it pay to borrow? |
| Short-term CreditorsCurrent ratio | Current Assets Current Liabilities | Short-term debt-paying ability without regard to the liquidity of current assets. | Does this customer have sufficient cash or other liquid assets to cover its short-term obligations? |
| Quick ratio | Cash + Marketable Securities + Account Receivable Current Liabilities | Short-term debt-paying ability without having to rely on inventory sales | Does this customer have sufficient cash or other liquid assets to cover its short-term obligations? |
| Long-term CreditorsDebt-to-equity ratio | Total Debt Total Equity | Amount of assets creditors provide for each dollar of assets owner(s) provide | Is the company’s debt load excessive? |
| Times interest earned | Net Income + (Interest + Taxes) Interest Expense | Ability to pay fixed charges for interest from operating profits | Are earnings and cash flows sufficient to cover interest payments and some principal repayments? |
| Cash .flow to liabilities | Operating Cash Flow Total Liabilities | Total debt coverage; general debt-paying ability | Are earnings and cash flows sufficient to cover interest payments and some principal repayments? |
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