Using And Understanding Financial Ratios

Logo: Using And Understanding Financial Ratios

Definition
Ratio analysis uses an amalgamation of financial or operating data from a company or industry to provide a basis for comparison. Every ratio measures a unique association that may have an impact on other ratios. In accounts, a financial ratio or accounting ratio is used to evaluate the overall financial condition of a company or other organization. Company owners, stockholders, or potential investors use ratio analysis to gauge viability, liabilities, and future performance.

A company owner should continuously evaluate the performance of the company by comparing its historical figures with those for industry competitors and even with those for successful businesses in other industries. To complete a thorough examination of a company’s proficiency, however, an owner needs to look at more than easily attainable numbers such as sales, profits, and total assets. Ratio analysis needs to be used to read between the lines of financial statements and make sense of the numbers. This will allow the owner to identify and quantify the company’s strengths and weaknesses, evaluate its financial position, and understand the risks it may be facing.

For private and institutional investors, ratios are important profit tools in financial analysis. Although ratios report mostly on past performance, they can be predictive too, and can provide indications of potential problem areas. Ratio analysis is used primarily to compare a company’s financial results over a period of time–a method sometimes called trend analysis. Trend analysis can also show how a company’s ratios stack up against those of other businesses, both within and outside the industry. Ratios allow for comparisons between companies, between industries, between time periods for a single company, and between a single company and its industry.

A multitude of financial ratios is available. The following are generally considered the most important:

- Liquidity Ratios measure how readily a company can meet its obligations.

- Profitability Ratios give an indication of the earnings and profitability potential of a company.

- Asset Management Ratios gauge how efficiently a company can change assets into sales.

- Debt Management Ratios indicate how debt-leveraged a company is, and how it can manage the debt in terms of assets and operating income.

- Dividend/Market Value Ratios measure how well a company uses its assets to generate earnings.

- Profitability Ratios indicate earnings and potential profitability.

Advantages
- Financial ratios use a combination of financial and/or operating data to allow potential investors to judge the viability, liabilities, and probable future performance of a company or industry.

- Ratio analysis permits analysts to read between the lines of financial statements and make sense of the numbers, thereby identifying and quantifying a company’s strengths and weaknesses.

- Financial ratios can provide indications of potential problem areas and allow corrective measures to be taken.

Disadvantages
- Due to different worldwide accounting standards, comparisons between companies and industries are not always possible.

- Financial ratios may not always reflect the true nature of a company’s accounts, as managers may attempt to gloss over problems.

- Financial ratios are based only on past performance; they cannot take into account future events.

Action Checklist
- Obtain as much information and compare as many ratios as possible before committing to an expensive decision.

- Make sure that you have analyzed the financial ratios in detail. If in doubt, consult an expert analyst.

- Be prepared to be involved in a long and complicated process of analysis. Some gray areas will not be resolved by financial ratios.

- Do not economize by taking shortcuts, because hidden problems may cost more in the long run.

Dos and Don’ts
Do’s
- In a comparative analysis of a company’s financial statements over a period of time, make allowances for any changes in accounting policies that occurred during the period.

- When comparing a business with others in an industry, allow for any material differences in accounting policies between the compared company and industry norms.

- Determine whether ratios were calculated before or after adjustments were made to the balance sheet or income statement, such as non-recurring items and inventory or pro forma adjustments. In many cases, these adjustments can significantly affect the ratios.

- Carefully examine any departures from industry norms.

Don’ts
- Don’t rely only on ratios when making decisions. Use market research to confirm the results.

- Don’t fall into the trap of thinking that financial ratios are infallible.

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