Introduction

Click here to view a video that explains the financial accounting definitions.

Financial reports were introduced in the previous Learning Unit, along with explanations of each type of report. These financial reports provide information about an entity’s financial position and its financial performance over a period of time. However, it is also important for managers to measure long term trends of performance.

The four key areas of measurement are:-

Efficiency: looks at how effectively an organisation is managing its assets

Liquidity: a measure of how easily an organisation’s assets can be converted to cash.

Profitability: provides information about whether the performance is improving or getting worse.

Capital structure: provides information about whether the owner’s capital or borrowed capital is used.

Financial analysis and interpretation are used to help with these areas of measurement. Ratio analysis is a form of financial analysis. A ratio measures the relationship between two measurable items by dividing one item by another item. A financial ratio is a relationship between two different items from the financial statements and can consist of figures taken from both the Balance Sheet and the Income Statement. Once the ratios are calculated, they can then be interpreted.

Ratio analysis can assist a manager to answer questions such as:-

• How effectively are assets being managed?
• How much debt can we afford?
• Is there enough cash to pay short–term debts?

Ratios can be used not only to analyse one’s own financial reports but also published competitor’s and other relevant companies' published reports.