A Detailed Explanation on the Working of Financial Ratio Analysis and its Types

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.

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.

How Does Financial Ratio Analysis Work?

To understand financial ratio analysis better, you need to 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 else the whole analysis process will go down the drain. The data from the financial statement is used to calculate the ratios. For example, by dividing current assets by current liabilities from the balance sheet, you will get the current ratio. 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 clients 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 Financial Ratio Analysis

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:

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.

Leverage Or Solvency Ratios

The leverage or solvency ratios will give an insight to your clients with regards to their ability to handle long-term debts. It is an important ratio which will help your clients 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

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.

Efficiency or Activity 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 and its investors and creditors to look at the operations and profitability and compare them. Under efficiency or activity ratios comes the following:

Profitability Ratios

Also called performance ratios, these ratios will check your client’s market performance through profit and loss. These ratios assess your client’s ability to generate revenue and identify any shortfall in returns. 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.

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. Financial ratio analysis reports of other clients can be used by your 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 a wide range of services, from bookkeeping and payroll to audit and corporate tax services. Our services have greatly improved your competitors’ quality and efficiency, and we can do the same for you. Contact us via our website form, and our team will respond to your inquiries promptly.

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