How Finance Works

Ratios make interpretation possible because single numbers in isolation are meaningless.

Ratios make interpretation possible because single numbers in isolation are meaningless. Ratios provide context. Financial analysis uses ratios to make sense of raw numbers, comparing them to other relevant figures. For example, a profit of $10 million is meaningless without knowing the revenue or assets used to generate it. Ratios like profit margin (net profit/revenue) or return on assets (net profit/total assets) provide a more meaningful picture of a company's performance. Balance sheet and income statement. Financial analysis draws on both the balance sheet (assets, liabilities, and equity) and the income statement (revenue, costs, and profits). Ratios can be used to assess a company's liquidity (ability to meet short-term obligations), efficiency (how well it uses assets), profitability (how much it earns), and leverage (how much it uses debt). Liquidity ratios: current ratio (current assets/current liabilities), quick ratio (current assets - inventory/current liabilities) Efficiency ratios: inventory turnover (cost of goods sold/inventory), receivables collection period (365/sales/receivables) Profitability ratios: net profit margin (net profit/revenue), return on equity (net profit/shareholders' equity) Leverage ratios: total debt/total assets, long-term debt/capitalization Ratios are not static. Ratios are not static; they should be compared across time and across companies within the same industry. For example, a high inventory turnover is good for a grocery store but not for a bookstore. By comparing ratios, you can identify trends, strengths, and weaknesses in a company's performance.

Many think that financial analysis and ratios are what finance is all about. In fact, it’s just the beginning. Cash is king. Finance prioritizes cash over accounting profits because cash is less susceptible to manipulation and better reflects a company's true economic performance. While accounting emphasizes net profit, finance focuses on cash flows, particularly free cash flow (FCF), which is the cash available to capital providers after all expenses and investments. EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) is a measure of cash generated by operations. Operating cash flow considers working capital and noncash expenses. Free cash flow (FCF) is the cash available to capital providers after all expenses and investments. Future matters more than the past. Finance is fundamentally forward-looking, emphasizing the importance of future cash flows over past performance. The time value of money dictates that a dollar today is worth more than a dollar tomorrow, so future cash flows must be discounted to their present value. This is done using a discount rate, which reflects the opportunity cost of capital. Discounted cash flow (DCF) analysis. DCF analysis is a method for valuing assets by discounting their expected future cash flows to their present value. This method is used to determine if an investment is worthwhile and how much it…