Ratio analysis involves the calculation and interpretation of key financial performance indicators to provide useful insights.
Financial information is always prepared to satisfy in some way the needs of various interested parties (the "users of accounts"). Stakeholders in the business (whether they are internal or external to the business) seek information to find out three fundamental questions:
(1) How is the business trading?
(2) How strong is the financial position?
(3) What are the future prospects for the business?
For outsiders, published financial accounts are an important source of information to enable them to answer the above questions.
To some degree or other, all interested parties will want to ask questions about financial information which is likely to fall into one or other of the following categories, and be about:
Is the business making a profit?
How efficient is the business at turning revenues into profit?
Is it enough to finance reinvestment?
Is it growing?
Is it sustainable (high quality)?
How does it compare with the rest of the industry?
Is the business making best use of its resources?
Is it generating adequate returns from its investments?
Is it managing its working capital properly?
Liquidity and gearing
Is the business able to meet its short-term debts as they fall due?
Is the business generating enough cash?
Does the business need to raise further finance?
How risky is the finance structure of the business?
What returns are owners gaining from their investment in the business?
How does this compare with similar, alternative investments in other businesses?