Meaning of Financial Ratio
Financial ratios are created with the
use of numerical values taken from financial statements to gain meaningful
information about a company. The numbers found on a company’s financial
statements – balance sheet, income statement, and cash flow statement – are
used to perform quantitative analysis and assess a company’s liquidity,
leverage, growth, margins, profitability, rates of return, valuation, and more.
Uses of Financial Ratio Analysis
A) To
Track Companies performance
Ratios can reveal trends in particular
industries, creating benchmarks against which the performance of all industry
players can be measured. Small businesses can use industry benchmarks to craft
organizational strategy and clearly measure their own performance against the
industry as a whole.
B) Make comparative judgments regarding company
performance
Comparing financial ratios with that
of major competitors is done to identify whether a company is performing better
or worse than the industry average. For example, comparing the return on assets
between companies helps an analyst or investor to determine which company is
making the most efficient use of its assets.
Top two types of Financial Ratios :
1) Liquidity ratios 2)
The liquidity ratio is a financial ratio that reveals whether a company has enough working capital to pay down its short-term debt. Working capital comes from current assets—notably cash and cash equivalents (such as marketable securities that can be sold to create cash flow).
The simplest way to calculate a
company's liquidity ratio is to divide its current assets by its current
liabilities. Often financial analysts focus squarely on short-term obligations;
longer-term financial obligations are designed to be paid back over many years
and do not necessarily reveal financial health.
Common Liquidity Ratios
Current ratio= current assets/ current liabilities
Quick ratio= (cash + short-term investments + accounts receivable)/
current liabilities
Cash ratio= (cash + short-term investments)/ current liabilities
The current ratio compares current liabilities with all current assets,
while the quick ratio and the cash ratio only consider the current assets that
can be converted to cash the quickest.
Quick ratio also considers accounts receivable, which is the amount a
company has to receive from its customers.
Cash ratio is the most stringent as it compares current liabilities
with only cash and short-term investments.
How to interpret above ratios?
The value of liquidity ratios should
ideally be close to 1 because this means that the company has just enough
short-term assets to fund its current liabilities.
A value below 1 means that the company
does not have enough current assets to fund its liabilities or repay its
short-term debt.
A value greater than 1 means that the
company has excess capital blocked in current assets. It can release some of
this and fund the business’ growth.
Profitability ratios are financial ratios that are used by the investors for
evaluating a company’s ability for generating income profit in relation to its
revenue, operating costs, balance sheet assets, and equity shareholders during
a particular period of time.
These ratios tell the investors how
well a company is using its assets for generating profit and value to its
shareholders.
Common Profitability Ratios :
Return on Assets = Net Income/Average Total Assets
This ratio measures the earning per rupee of assets
invested in the company. A high ratio represents better the company is.
Return on Equity = Net Income/Average Stockholder Equity
This ratio measures Profitability of equity fund invested
the company. It also measures how
profitably owner’s funds have been utilized to generate company’s revenues. A
high ratio represents better the company is.
Earnings Per Share = Net Income/Number of Common Shares Outstanding
The earnings-per-share ratio is similar to the
return-on-equity ratio, except that this ratio indicates your profitability
from the outstanding shares at the end of a given period. This ratio measures
profitability from the point of view of the ordinary shareholder. A high ratio
represents better the company is.
We can conclude that, the common
language and understanding of ratios helps investors and analysts to evaluate
and communicate the strengths and weaknesses of individual companies or
industries. Fundamental analysis is the term given to the use of financial
ratios in determining the relative strength of companies for investing
purposes. A careful analysis of a company's ratios can reveal which companies
have the fundamental strength to increase their stock value over time and are a
potentially profitable opportunity, while pointing out the weaker players in
the market as well..
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Very good article.
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