Analyzing financial statements using ratios

The concept of financial statements

The financial statements (in English: Financial Statements) are summary reports that explain the nature of the companies’ use of funds, whether they are their own, or they are responsible for managing them such as the funds of shareholders and lenders. The financial statements also help determine the value of the company’s current financial position; By studying its financial statements, financial statements are defined as financial reports that companies provide to investors and shareholders, and contribute to clarifying the details of their financial conditions, and include documents indicating loss and profit accounts, and others.

Another definition of financial statements is that they are official records that contain financial information related to businesses, and they are presented in a unified and organized way that helps to understand them easily.

Analyzing financial statements using ratios

Analysis using ratios (in English: Ratio Analysis) is a financial analysis method that seeks to convert quantities of numbers into ratios in order to apply comparisons between them; By relying on a comparison between the current and previous ratios of companies operating in a similar or different industry, this type of analysis contributes to identifying the weaknesses and strengths of the company, and the analysis of financial statements is defined using ratios; It is a means aimed at studying the various relationships between numbers and amounts in the financial statements of companies; In order to determine the extent of their success in the labor market.

Another definition of analyzing financial statements using ratios is a tool used to build a comparison between the various relationships in various financial sectors. Information for analyzing financial statements is obtained through financial statements such as the income statement and the balance sheet.

Sections of financial ratios

The financial ratios used in analyzing the financial statements are divided into the following:

• Liquidity Ratios: They are the ratios that measure the short-term financial capacity of the company; That is, it is interested in knowing the extent to which the company can pay its financial obligations within a short period, and this financial ability contributes to explaining the nature of current financial liabilities based on the company’s negotiable assets, which can be converted into cash in a period of time equal to the maturities of current liabilities. The existence of sufficient financial liquidity among companies, the possibility of a risk in financing, which leads to a decline in their credit rating, and among the most important liquidity ratios:
  • Trading Ratio: It is the ratio that is calculated by dividing current assets by current liabilities.
  • Quick Ratio: It is the ratio that is calculated by subtracting the value of inventory from the value of current assets, and then dividing the output by the value of current liabilities. The importance of this ratio appears through its role in measuring the ability of projects to pay short-term financial obligations, without the need to sell the value of inventory.
• Financial Leverage Ratios: They are the ratios that concern the degree of financing of the company; by relying on indebtedness to others (leverage); That is, it is used to measure the company’s ability to pay all the debts incurred by it at the date of its maturity date, regardless of the nature of these debts, whether they are short or long-term, and among the most important financial leverage ratios:
  • Debt ratio to net assets: It is the ratio that measures the company's ability to rely on other people's money. In order to use it to finance its needs, this ratio is calculated by dividing the net value of all debts by the net asset value, and the decrease in this ratio indicates a decrease in the fixed burdens incurred by the company, while its increase constitutes an increase in the financial returns of the owners, and makes them abandon the increase in capital depending on attracting New partners.
  • Capital structure ratio: It is the ratio calculated by dividing net long-term debt by long-term financing sources. This ratio is used to judge the nature of financial risk.
  • Coverage ratio: It is the ratio that measures the company's ability to repay loan interest. By relying on the value of its profits, it is calculated by dividing the value of income before taxes and interest by the value of interest paid annually.
• Profitability Ratios: They are the ratios that measure the company's ability to generate profits. By relying on its assets, sales, and ownership rights, and among the most important profitability ratios:
  • Gross Profit Ratio: It is the ratio used to indicate management efficiency in supporting sales and controlling costs. It is calculated by dividing gross profit (sales value - cost of goods for sale) by total sales.
  • Operating profit margin ratio: It is the ratio that is used to measure the operational efficiency of the company, and is calculated by dividing the value of operating profit by total sales.
  • Gross Income Ratio: It is the ratio used to measure the ability of sales to produce total income, and is calculated by dividing total income by total sales.
• Activity Ratios: They are the ratios that measure the efficiency of managing the company's resources; by comparing its sales with its investments within a group of assets; That is, it contributes to determining the company's efficiency by distributing financial resources to various assets, and also studies the extent to which assets are efficiently used to produce the largest amount of services and goods, and among the most important activity ratios:
  • Accounts receivable turnover: It is the number of times during the year that accounts receivable are collected, and it is calculated by dividing total sales by the value of accounts receivable.
  • Inventory turnover: It is the number of times the company purchases a quantity of goods for the purpose of selling it. Inventory turnover contributes to measuring the percentage of administrative efficiency of the company to follow up on its assets, and to maintain assets within their ideal limits appropriate to the size of its operations. The inventory turnover ratio is also useful in determining the appropriateness of investment within the inventory. Commodity.
  • Fixed assets turnover: It is a measure of the management’s efficiency ratio based on its net assets in order to support its sales. An increase in this ratio indicates the distinguished use of assets. This indicates that the company cannot produce an appropriate sales volume, compared to the nature of the investment used.

Steps to analyze financial statements using ratios

The application of financial statement analysis using ratios depends on a set of steps, namely:

• Calculating ratios for common size; By relying on the company's balance sheet.
• Calculating ratios for common size; Through the financial statements of the income statement.
• Using the balance sheet data to calculate both the current financial ratios and the quick financial ratios.
• Applying the calculation of both the ratio of debt and total sales to the current capital of the company.

Note: The application of these calculations is based on the mathematical laws mentioned in the previous paragraph.