Financial statements both report on a firm's position at a point in time and on its operations over some past period. However, their real usefulness lies in the fact that they can be used to help predict the firm's future earnings and dividends as well as the risk factor of these cash flows. From equity investor's viewpoint, predicting the future is what financial statement analysis is all about. From management's viewpoint, financial statement analysis is useful both as a way to anticipate future conditions and, more important, as a starting point for planning actions that will influence the future course of events for the firm.

Financial ratios are designed to show relationships among financial statement accounts. Ratios put numbers into perspective. They provide the necessary comparisons in order to comprehend the firm's current situation along with it's past performance and its future potentials and threats. Such comparisons are made by ratio analysis. It must be pointed out that according to financial analysts, a single ratio is relatively useless in making relevant evaluations of a firm's health. Thus, if it is to be effectively interpreted a ratio must be systematically compared with other ratios of the examined company, or even the industry competitors during a specific period of time.

Analysts who use financial ratios extensively may be characterized as belonging to three main groups. Managers, who use ratios to help analyze, control, and improve the firm's operations, credit analysts, who analyze ratios to help ascertain a company's ability to pay its debts, and securities analysts, who are concerned with a company's efficiency and growth prospects. As it is expected, each group of analysts has specific areas of interest, which it wishes to investigate. Therefore, ratios may be characterized into specific task groupings. The five group categories are liquidity ratios, asset management ratios, debt management ratios, profitability ratios and market value ratios.

One of the first concerns of most financial analysts is liquidity. It is actually the ability of the firm to measure its maturing obligations. By relating the amount of cash and other current assets to the current obligations, ratio analysis provides a quick and easy-to-use measure of liquidity. The second groups of ratios, the working capital ratios, measure how effectively the firm is managing its assets. If it has too many assets, its interest expenses will be too high, and hence their profits will be depressed. On the other hand, if assets are too low, profitable sales may be lost. Thus, having the proper level of each type of asset is considered important. The stock turnover ratio is defined as cost of sales divided by inventories. These ratios suggest that the company hold extensive stocks of inventory; excess stocks are, of course, unproductive and represent an investment with a low or zero rate of return.

Profitability is the net result of a large number of policies and decisions. Although the ratios examined thus far provide some information about the way the firm is operating, the profitability ratios show the combined effects of liquidity, asset management, and debt management on operating income and net income. Return on capital employed is calculated by dividing the net profit before tax with the share capital and reserves.

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Jonathon Hardcastle writes articles on many topics including Finance, Business, and Home Improvement