A logical follow-up after working your way through Balance Sheets and P&L is to look into ways to gain additional insights in it. The most logical and easy way is to compare different periods, such as current year vs last year or current month vs last month. If there is a budget or an industry benchmark, you should compare it with that as well.
There is however another way to quickly understand what you are looking at, and this is called ratio analysis. With a bit of luck this can easily be done in an Excel sheet, and if constructed well it will end up to be a set of KPIs that highlight potential problems ahead. Let’s take a deeper look at what ratios analysis entails.
They typically fall into four different categories, I like to think of them as ‘ratio families’:
Let’s start looking into Liquidity:
Potential subcategories will be:
• Current ratio
• Acid test
• Net working capital
• Need for net working capital
• Days of Sales Outstanding
• Days of Supplier Credit
• Inventory Turnover
The second set of ratios, Profitability, is much more commonly known. There are:
• Operational profitability
• Return on Equity
• Return on Assets
Finally Solvency ratios will tell you everything on the long term financing:
• Debt-to-equity ratio
• Debt coverage
• Financial leverage
Finally, Cash flow is a crucial, but often misunderstood, concept that needs additional clarification.