Financial analysis entails selecting, assessing, and interpreting financial data and other essential information to identify risks and returns linked with an investment. It is utilized in assessing operational efficiency, credit policy effectiveness, and company creditworthiness. Financial analysis can be carried out through ratio analysis. Financial ratios enable the entity to investigate the link between and among various accounts. They also depict the entity's financial performance in relation to that of the competitors. They need to be computed over time and compared to those of other entities for the assessment to be meaningful. For instance, Coca-Cola's financial ratios computed for the last three years can show whether the entity's financial performance is improving. Such outcomes are meaningful to the current shareholders and investors. The entity's financial ratios can be compared to the entity's rivals, for instance, Pepsi Company, to determine the position of Coca-Cola in the beverage industry. Financial ratios comprise four main types, including liquidity, activity, profitability, and leverage ratios.
Liquidity ratios depict the entity's capacity to settle its short-term obligations utilizing assets that are easily convertible to liquid assets, including cash. The firm's level of liquidity is determined by its operating cycle and level of current assets compared to its current liabilities. The operating cycle is the time taken to convert cash investments into cash. The firm's operating cycle is computed by adding the days of inventory and days of receivable. The most common liquidity ratios entail the current, quick, and cash ratios. Current ratio is determined by dividing the firm’s current assets by the short-term liabilities. In the computation of the quick ratio, the inventory amount is subtracted from the current assets then the result is divided by the short-term liabilities. The cash ratio is computed by dividing the firm’s cash amount by the short-term liabilities. A high liquidity level is depicted by the availability of more current assets than current liabilities. Companies such as Coca-Cola aim to maintain a high amount of working capital to easily meet their immediate obligations when they fall due.
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Activity ratios are used to illustrate how well the entity's assets are used. In this respect, they assess the benefits produced by particular assets owned by the firm. Examples of activity ratios entail inventory turnover, debtors' turnover, and asset turnover ratios. The inventory turnover metric is computed by dividing the entity's cost of sales by the inventory. The debtors' turnover is computed by dividing the entity's credit sales by the accounts receivables. The asset turnover ratio is calculated by dividing the credit sales by total assets.
Profitability ratios show whether the entity can generate profits from its key operations. Examples include gross margin, operating profit margin, net margin, return on assets, and return on equity. The gross margin depicts the amount left after covering the cost of goods. It is determined by dividing the gross profit by the entity's total revenue. The operating margin is determined by dividing the operating income by the total revenue, while the net margin is determined by dividing net income by the total revenue. The return on assets and return on equity are computed by dividing the net income by the aggregate assets and shareholders' equity, respectively.
The leverage ratios depict the company's financial stability and how the entity finances its assets. Companies including Coca-Cola finance their assets through equity and debt. Examples of leverage metrics entail the debt-to-asset ratio, debt-to-equity ratio, interest coverage ratio, and equity multiplier ratio. Companies, for instance, Coca-Cola, have managed to survive for long periods due to their low level of debt.
