What Internal & External Risks Do Financial Ratios Show?
Companies generate financial statements to obtain information about the status of their financial and operational health. Analysis of these statements provides in-depth information that helps identify issues and concerns that the company and its management must address. Calculating financial ratios and comparing them to industry norms and internal trends is an analysis method. Financial ratios also provide insights into the risks companies encounter and how to address those risks.
Liquidity Ratios
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Financial ratios are a very broad category. Any ratio generated from comparing numbers on a financial statement is a financial ratio. Liquidity ratios, a subset of financial ratios, assess a company's ability to meet its short- and mid-term financial obligations. Without sufficient liquidity to pay its bills, a company can fail. The less liquidity, the greater the likelihood of failure and the sooner the company is likely to fail. Liquidity ratios point out the risks inherent in setting a feasible invoice and collection policy, sales force incentive structures and procurement policies and managing cash flow.
Leverage Ratos
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Analysis of certain financial ratios, especially those related to leverage, can also help identify issues that can lead to a firm's failure. The availability of debt and the current interest rate level are external environmental risk factors that appear in leverage ratios. A company's internal policies on the usage of debt and the mix of equity and debt in its capital structure are internal risk factors. A supply restriction that impacts the price of certain assets also impacts leverage ratios.
Profitability Ratios
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Profitability and positive cash flow are the key drivers of a business's long-term success and viability. Profitability ratios compare various income statement numbers to total sales. This helps identify issues including inventory problems. Inventory turnover points to external risk factors including market demand or supply and sourcing disruptions. It can point to internal risk factors including location assessment and marketing effectiveness. These ratios can identify other risks including regulatory compliance, training needs and rental and maintenance rates.
Rates of Return
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Rates of return are yet another group of financial ratios. These show how well a company is performing operationally. The capital-raising environment impacts this ratio. The easier it is to raise capital from external investors, the more likely certain companies will pursue that option over debt or slower growth. Higher required internal rates of return are internal risks. Additional internal risks include a company's operating or competitive environment, its internal procedures and management capability.
References
Writer Bio
Tiffany C. Wright has been writing since 2007. She is a business owner, interim CEO and author of "Solving the Capital Equation: Financing Solutions for Small Businesses." Wright has helped companies obtain more than $31 million in financing. She holds a master's degree in finance and entrepreneurial management from the Wharton School of the University of Pennsylvania.