Financial Statement Ratio Analysis - Essay Example

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Imagine a scenario where you decide to start a new business, let's say of manufacturing cookies and selling them in your neighborhood. So you are not only the manager but also the owner (major share holders) of the company. It's a small closely knit business, but let's see its activities a little closely…
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Download file to see previous pages (basic raw material) plus an oven to bake the cookies (plant and machinery), and also a place to keep the oven (premises). Plus, not to forget, skilled labor (You've got to know how to make cookies OR hire someone who can.). Last but not the least, your have to find a way to sell the cookies - either hire a salesman with a fixed pay or hire an agent with a fixed share in profits (Selling and distribution overhead). All these factors would sum up to be the 'Cost' incurred on making the cookies. Based on this cost, you may decide your expected 'Selling Price' and thus the 'Contribution' per unit. (Activity Ratios)
Also, to keep things going, you would need enough money readily available for your short term requirements (like buying more raw materials, paying rent, electricity bills, wages to employees, etc.) as well as for long term requirements (paying off debts, more money for further expansion, etc.). Also, you very well know that your creditors will supply you material on credit only if you are worthy of it. i.e. you are able to pay them in time. (Liquidity Ratios)
In both the cases, money doesn't come free of cost. Business should be profitable enough. Both the parties would again, check your credibility as well as the worthiness of the business. In the first case, you would be liable to pay a fixed interest to your bank, regardless of what you make. In the second, you've got to make enough money so that you and your friend are glad that you invested in the business. Therefore, to be sure of what you are doing, at every moment you would be analyzing your 'profitability ratios', like you would constantly be calculating your earnings as against your investments (EPS) and comparing it with what ever was the next best use of your money (opportunity cost).
Further, you could even decide your debt-equity ratio - how much share in the profit should be sacrificed for funds and how much should you borrow from the bank. And if you make handsome profits, how much of it should be invested back in the business (retained earnings). Or maybe you have better uses for your money and decide to take a further loan against your business from the bank so as to free your capital and maximize your returns on investment (leverages). Thus, organizing your 'Capital Structure' is a very basic and important decision.
The point behind this entire example is that the smallest of small business would require analyzing their basic ratios to know how well they are doing. Without comparing various financial figures (ratios) we cannot make an informed decision. Without these, you will never know what can go wrong with your business. Before staring any business you must know in advance what you may expect from the business and what you should be expecting in return for your time, effort and investment. At any stage of the business you must know how much have you given to the business and how much the business can return back and what is the present condition as well ...Download file to see next pagesRead More
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