Introduction to Ratio Analysis & Interpretation

Accounting Users

The users of financial statements will analyse and interpret financial statements in order to extract the information they require. However, it is important to understand that financial ratios on its own are useless and in order for them to be effective, they need to be compared too:

  • Previous years
  • Other companies
  • Industry averages

Note when interpreting financial information through ratios, just recognising that a ratio has gone up or down is not enough, the reason behind the change should be considered.

Some examples of information a user may need are:

Users Need Information
Shareholders/potential investors Current shareholders make investment decisions which require awareness of the risk and return on investments. business to pay dividends. In addition, the shareholder may want to know whether the business is going to be in financial difficulty/insolvency.
Lenders Will the business be able to repay the loan including interest and how are current lenders treated, do they pay it late or early.
Suppliers How long does the business take in paying for supplies.
Customers Will the business continue to operate in the future.

The key financial ratios include:

  1. Profitability and return
  2. Long-term solvency and stability
  3. Short-term solvency and liquidity
  4. Efficiency (turnover ratios)
  5. Shareholders’ investment ratios

Financial ratios provide users of financial statements to interpret financial information for their own focuses/purpose. For example:

  • Shareholders- They may focus mainly on the gearing and dividend cover ratio as they measure risk and the returns of the company. They will also include solvency ratios.
  • Lenders- They will focus on liquidity and long term solvency ratios to assess the ability of the business to pay debts.
  • Customers/suppliers- They focus on current liquidity and profitability of company to assess likely hood of future liquidity.