A Detailed Explanation on the Working of Financial Ratio Analysis

No one can stop the rise of your UK accounting practice if your clients are satisfied with your services. One way to satisfy them is by giving them an accurate and honest financial health picture. A clear financial picture will help your clients know where they are lacking, and accordingly, they can make correct and informed decisions. One way of giving them a clear financial picture is through financial ratio analysis.

What is Financial Ratio Analysis, and Why is It Important?

For those not aware, financial ratio analysis is a method of analysing your client’s financial statements, such as balance sheets and income statements. Through this analysis, accounting practices will learn about their clients’ liquidity, operational efficiency, and profitability. In simple terms, financial ratio analysis goes through multiple financial data of your clients.

However, it is important to note that financial ratio analysis is vast; it contains multiple ratios used to analyse and predict financial performance and future growth and trajectory. Hence, accounting practices need to have a deeper understanding of its workings. This way, you can help your clients make informed business decisions regarding creditworthiness, investment decisions, and overall business strategy based on ratio analysis.

Possessing such vast information on financial ratios requires research and a big team. However, accounting practices these days are facing talent shortages due unavailability of the right candidates, leading to the unavailability of this knowledge. To overcome the challenge of talent shortage and expertise, you can opt for accounting outsourcing. But more on that latter, let’s focus on the workings of financial ratio analysis.

How Does Financial Ratio Analysis Work?

To understand financial ratio analysis better, you must know how it works. A series of steps must be followed for the financial ratio analysis to work accurately. These steps are as follows:

• Getting the Data from the Financial Statements: It is important to get the right data from the financial statements, or the whole analysis process will fail. The data from the financial statements is used to calculate the ratios. For example, the current ratio is calculated by dividing current assets by current liabilities from the balance sheet. The net profit margin is calculated based on the data in the income statement.
• Comparisons with Benchmarks: The main objective of financial ratio analysis is to check the performance of your clients. Your accounting practice will have to compare your client’s ratios with industry benchmarks or historical data, thus giving your clients an honest picture. For example, your client’s profitability ratio will be compared against the industry average, giving your clients an understanding of their position in the market.
• Analysing the Trend: While doing financial ratio analysis for your clients, it is important to keep an eye on the trends that will give you an idea of their financial performance. By properly analysing the trends, you can forewarn your clients regarding any issue that will hinder their performance. For instance, an increasing trend in profitability ratios indicates an improvement in efficiency, while a declining trend indicates a possible signal of a problem.
• Evaluating Relationships Between Ratios: Financial ratios are interdependent, and their relationships provide deeper insights. For example, the debt-to-equity and interest coverage ratios can help assess the client’s leverage and ability to service debt.

We admire your confidence in your in-house team to handle financial ratio analysis. We are confident that adequate training will enable them to handle the task. However, financial ratio analysis is a complex responsibility that can be time-consuming. Such a situation will leave your teams with less time to attend to other important accounting responsibilities. To avoid this, you can use the outsourced year end services offered by outsourced accounting service providers.

Types of Analysis in Finance: Understanding the Bigger Picture

The financial ratio analysis is a vast area to work on. Various types of ratio analysis cater to your client’s financial health, from how to cover the debt to how to utilise assets. Also, to be taken into consideration that ratios are time sensitive because they use data that changes with time. So, you can check your client’s data and use the ratios to compare it with various periods to get a general idea of your client’s growth or decline over time.

Some of the types of financial ratios are:

1. Liquidity Ratio

Using liquidity ratios, you will be able to identify your client’s ability to pay debts and other liabilities. By analysing liquidity ratios, you will be able understand whether your client have enough assets to cover its long-term commitments or whether the expenses will be covered by the current cash flow. If it’s a positive answer, then your client has sufficient liquidity otherwise, there will be a big problem.

Some of the expected liquidity ratios are:

• Current ratio: You can determine how effectively the client can fulfil its financial responsibilities in the upcoming year by looking at the current ratio.
• Working capital ratio
• Quick ratio: The quick ratio will assess your client’s marketable securities, receivables, and cash against its liabilities. This gives you an idea about your client’s ability to pay for its current obligations.

2. Leverage Ratios

Leverage or solvency ratios will give your clients insight into their ability to handle long-term debts. This important ratio will also help them determine whether they can handle short-term obligations and cash flows.

Some of the leverage or solvency ratios are

• Debt ratio: The debt ratio compares a client’s debt to its assets as a whole.
• Interest coverage ratio: The interest coverage ratio gives insights into a client’s ability to handle the interest payments on its debts.
• Debt-to-equity ratio: A debt-to-equity ratio compares your client’s overall debt to its investor-supplied capital.
• Debt to tangible net worth
• Total liabilities to equity
• Total assets to equity

3. Return on Investment Ratios

Such ratios calculate the return on investment concerning the investment cost. Return on investment ratios give a broad idea of investment profitability. Under it comes the following ratios:

• Return on equity: ROE is also the return on net assets, as shareholders’ equity is the total assets minus debt.
• Return on assets: ROA measures the efficiency of your client in generating earnings from its assets.

4. Efficiency Ratios

It helps in checking how well your clients are operating their assets to make income. It helps you find out how much time it takes for your clients to collect cash from customers or to make inventory sales and bring in cash. These ratios are also used by your clients, investors, and creditors to look at the operations and profitability and compare them. Under efficiency or activity ratios comes the following:

• Inventory turnover: This ratio can indicate how efficient your client is at managing its inventory. A high ratio implies either strong sales or insufficient inventory.
• Receivables turnover: This indicates how quickly net sales are turned into cash.
• Payables turnover: Payables turnover is a short-term liquidity measure that shows how many times your client pays off its accounts payable during a period and indicates short-term liquidity.
• Fixed asset turnover measures how efficient your client is in generating sales from its fixed assets, such as property, plant, and equipment.
• Total asset turnover: Fixed asset turnover measures how efficiently your client uses its assets to generate sales.

5. Profitability Ratios

Also called performance ratios, these ratios will check your client’s market performance through profit and loss. These ratios help check your client’s capability to generate revenue with its expenses to arrive at a desired rate of return and recognise if there is any shortfall. It includes ratios like:

• Gross profit margin: A gross profit margin ratio will tell you the relation between your client’s gross sales and profits.
• Operating profit margin: The operating profit margin indicates your client’s profit margin before interest payments and taxes.
• Net profit margin: Net profit margin indicates your client’s net margins. A high net profit margin is a good indication of an efficient business.

6. Market Ratios

The most frequently used ratio for conducting fundamental analysis, the market ratios are highly preferred by investors before they make any investments in a particular firm. Market ratios help them in predicting future performance and earnings.

Under market ratios comes the following:

• Dividend yield
• P/E ratio
• Earnings per share (EPS)
• Dividend payout ratio

How to Perform Financial Ratio Analysis Effectively

To perform the financial ratio analysis smoothly, you will have to follow a set of step-by-step processes. These steps are as follows:

1. Define the purpose of the analysis
2. Gather financial statements
3. Choose relevant ratios
4. Calculate the ratios
5. Benchmark and compare
6. Interpret the results
7. Use visualisation tools
8. Provide recommendations

Limitations of Ratio Analysis: Things to Keep in Mind

Using ratio analysis, you can help your clients make investment decisions by helping them understand a company’s future growth and performance. However, companies have started changing company ratios to look more attractive without making any fundamental changes. Hence, you need to understand the variables behind ratios, what information is shared and not shared and how it is prone to manipulation. Ratios must not be seen in isolation but with other metrics and ratios so that your clients can get a clear picture of their financial status. Here are some other key limitations of ratio analysis considerations:

Lack of Context

Ratios provide insights in the form of numbers, but it does not fully cover the context. Various factors like market conditions, economic trends, or unique business circumstances influence these numbers. This context is necessary for decisions based on ratio analysis to be accurate.

Dependence on Accurate Data

The accuracy of ratio analysis depends on the accuracy of the financial data. Any errors in bookkeeping records will result in distortion in ratio. A flawed ratio will only lead to incorrect insights and conclusions.

Inconsistencies Across Industries

Every business is different from the others, and operational dynamics also vary widely. Hence, it is risky to make direct comparisons using ratios. For instance, some of your clients have run businesses in which a high debt-to-equity ratio is normal, but it is considered risky for others. You must understand your client’s business in detail before you start analysing the ratios.

Historical Nature

Ratios are created using past data and may not show the current financial position or future position of your client’s business. Market volatility, new investments, or structural changes can make ratios made of past data insignificant for present-day decision-making.

Why Ratio Analysis is Essential for Your Client’s Business

As an accounting practice in the UK, it is your responsibility to guide your clients towards financial clarity, and ratio analysis is a vital tool in achieving that. It provides you with information about your client’s financial health, enabling you to guide your clients effectively. That’s not all there are many other reasons why ratio analysis is essential for your clients:

Strategic Planning

Suppose you are developing a a long-term strategy for your client; you will need ratio analysis. By analysing profitability, liquidity, and solvency ratios, you will be able to identify growth opportunities and areas of concern that require improvement for your clients. Such insights will allow you to devise strategies for expansion, cost control, or operational efficiency.

Performance Monitoring

Tracking your client’s financial performance is important so that they can understand how well they are doing. Ratio analysis will help you in analysing your client’s current performance against past trends, industry benchmarks, or competitors. Through this monitoring, you can measure the progress made, set realistic goals, and maintain focus on KPIs.

Informed Decision-Making

Informed decision-making is the foundation for your client’s business success. Ratio analyses offer clear and quantifiable numbers that can be helpful when securing loans, adjusting prices, or managing cash flow. These numbers will give your insight that can minimise risk and maximise profits for your clients.

Frequently Asked Question(FAQ)

Conclusion

The main purpose of this blog is to explain the complex subject of financial ratio analysis in the simplest possible terms. By understanding financial ratio analysis better, you will be able to make life easier for your clients, thanks to its benefits.

With a complete understanding of the types and workings of financial ratios, you will be able to simplify complex numbers in the financial statements, thus drawing your clients’ attention where it is needed. By drawing your client’s attention to problems and with adequate simple data in their hands, your clients will be able to evaluate their financial position and make decisions accordingly to improve compliance with HMRC and profitability. Your clients can use financial ratio analysis reports of other clients to compare and understand their financial position.

We admit that financial ratio analysis is more complex than we are trying to make it out, and even after understanding the concepts thoroughly, you will require help. In such situations, a professional UK outsourced accounting service provider can become your pillar of support. Many UK-based service providers offer their services in ratio analysis to countless accounting practices; among them is the rising star, the highly professional Corient UK.

We are an outsourced accounting service provider based in Coventry, United Kingdom. Our expertise is in providing outsourced year end services that cover ratio analysis. Still, we offer various services, from bookkeeping and payroll to audit and corporate tax services. Our services have worked wonders for many of your competitors, especially in improving their quality and efficiency, and we can do the same for you. Feel free to contact us with your questions or requirements using our website contact form, and our executives will contact you as soon as possible.

We are looking forward to a long-term and sustainable partnership.