Ratio Analysis: Explanation and formation of Income statement & balance sheet

📊 Ratio Analysis: Explanation and Formation of Income Statement & Balance Sheet

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🔍 Part 1: Ratio Analysis

✅ What is Ratio Analysis?

Ratio analysis is a quantitative tool used in financial analysis to evaluate a company’s performance, efficiency, profitability, and financial health by comparing different items in the financial statements.

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🧮 Why is Ratio Analysis Important?

• Helps in decision-making for management, investors, and creditors.
• Assists in benchmarking performance over time or against competitors.
• Identifies strengths and weaknesses in financial structure.

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📚 Types of Financial Ratios:

Type	Purpose	Common Ratios
Liquidity Ratios	Can the firm meet short-term obligations?	Current Ratio, Quick Ratio
Profitability Ratios	Is the business earning profits efficiently?	Net Profit Margin, ROE, ROA
Leverage Ratios	How much debt is the business using?	Debt-to-Equity, Interest Coverage
Efficiency Ratios	How well are resources being used?	Inventory Turnover, Receivables Turnover
Market Ratios	How is the business valued in the market?	EPS, P/E Ratio, Market-to-Book Ratio

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📘 Part 2: Formation of Financial Statements

To do ratio analysis, we need two key financial statements:

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📄 1. Income Statement (Profit and Loss Account)

✅ Purpose:

Shows the company's revenues, expenses, and profit or loss over a specific period (usually quarterly or annually).

🧱 Basic Format:

Income Statement (for the year ended…)

Revenue (Sales)
– Cost of Goods Sold (COGS)
= Gross Profit
– Operating Expenses (e.g., salaries, rent, marketing)
= Operating Profit (EBIT)
– Interest
= Profit Before Tax (PBT)
– Taxes
= Net Profit (or Net Income)

📌 Used in Ratios Like:

• Net Profit Margin = (Net Profit / Revenue) × 100
• Interest Coverage Ratio = EBIT / Interest Expense
• Return on Equity (ROE) = Net Profit / Shareholder’s Equity

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🏦 2. Balance Sheet

✅ Purpose:

Shows the financial position of a business at a specific point in time. It lists the assets, liabilities, and equity.

🧱 Basic Format:

Balance Sheet (as on a date)

ASSETS
  Current Assets
    - Cash
    - Accounts Receivable
    - Inventory
  Non-Current Assets
    - Property, Plant & Equipment
    - Long-term Investments

TOTAL ASSETS

LIABILITIES
  Current Liabilities
    - Accounts Payable
    - Short-term Debt
  Long-term Liabilities
    - Long-term Loans

EQUITY
  - Share Capital
  - Retained Earnings

TOTAL LIABILITIES + EQUITY

📌 Assets = Liabilities + Equity (Accounting Equation)

📌 Used in Ratios Like:

• Current Ratio = Current Assets / Current Liabilities
• Debt-to-Equity Ratio = Total Debt / Total Equity
• Return on Assets = Net Profit / Total Assets

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🧠 How Ratio Analysis Works Together with Financial Statements:

• Income Statement gives data for profitability and efficiency ratios.
• Balance Sheet gives data for liquidity, leverage, and financial stability ratios.
• Together, they form the foundation of financial analysis.

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📌 Conclusion:

Ratio analysis is a powerful tool, but it relies on well-prepared income statements and balance sheets. By examining the relationships between items in these statements, businesses and investors can gain deep insights into financial health and performance.

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