3 - Assessing financial health

Abstract

Financial ratios are a primary tool for the analysis of financial statements, and they provide the basis for valuing a business and appraising its financial health. A large number of ratios could be calculated for a firm; however, only a few are really meaningful for evaluating its financial health. This chapter mentions the four key dimensions to a firm's financial health and the categories of financial ratios—profitability ratios, efficiency ratios, financial (leverage) ratios, and liquidity ratios. Efficiency ratios evaluate how effectively capital is employed within the firm. The emphasis is on the scale of business generated off the capital base rather than on profitability directly. The asset turnover ratio measures how effectively the assets are being worked to generate business as reflected in the revenues. This ratio is, of course, affected by the funding of investments. If a new production plant is purchased toward the end of the financial year, the balance sheet reflects the full impact in the asset base; however, the firm will not yet have enjoyed a full year's revenue from the plant. Thus, the ratio will look a little worse when major capital projects are implemented.