Chapter 9, Problem 1Q

1. Why are ratios and trends used in financial analysis?

To determine

Explain the reasons for using ratios and trends in financial analysis.

Explanation of Solution

Financial analysis: Financial analysis means evaluating financial statements to ascertain performance such as profitability, solvency and liquidity of a business.

Ratios and trends are the necessary tools of financial analysis. Ratios and trends help the interested users to make informed decisions. Ratios and trends are explained as follows:

Ratios: Ratio analysis expresses the relationships between different items reported in a set of financial statements. These are used to evaluate capabilities, profitability, and overall performance of a company. The absolute amounts ascertained in the trends often convey little meaning. These ratios convey the results in relative term which are useful for decision making. Analysts can assess the profitability, solvency and liquidity of a business using this tool.

Trends: Trends are a tool in financial analysis to know how the company has been performing over the time period and with respect to its industry. Trends during the months, quarters or years are useful for analysing the financial statements of a company. These trends reveal the results in absolute terms and are helpful when comparing those results with other companies or with different time periods. Horizontal analysis and vertical analysis are examples of trends.