Financial ratios, also known as Accounting Ratios, are used to measure the performance of a business organization. It is a part of the quantitative fundamental analysis. Almost every subject of finance covers financial ratio analysis as it is one of the most important parts of financial analysis for making a decision regarding investment.
When an investor decides to invest in a specific stock of a company, he/she needs to measure the company performance by using different methods of financial analysis. Ratio analysis gives an investor a precise understanding about the company’s current financial status.
Financial Ratios are the most popular and common tool all over the world. It gives lucrative result if used properly.
Financial or accounting ratios are calculated by using two different numbers taken from financial statements of a company. In accounting or finance, these ratios are calculated to analyze, evaluate, and make different types of decisions within an organization. These financial ratios are used by the managers of a company to conduct the operation more efficiently, potential investors who have an interest in investing in a business, shareholders of a company who want to hold or sell the ownership, or analysts who analyze a company’s performance.
Financial ratios are used to understand the current standing of a company, the strength and weakness, and the potentiality of a business organization.
Financial Ratios are Used by Different Organizations
Managers calculate financial ratios to make an effective decision. For an example, looking at the working capital ratio, a manager can understand the working capital efficiency of the business. When measuring the potentiality of a company, a financial analyst often compares the ratio of one company with the industry average. They take all the companies from the same industry and make an average and then compare it with the chosen companies. Financial ratio analysis adds great value to conduct the banking business. For an example, the asset utilization ratio tells a manager if the employed assets are being utilized properly or not.
Source of Data for Financial Ratio Analysis
Financial information is very important for calculating financial ratios. It must be collected from reliable source. These are publicly available information. The major source of collecting data for financial analysis is financial statements. The values are taken from the income statement, balance sheet, cash flow statement, and retained earnings statement.
The other sources of information are the published news, company profile, the stock market under which the company was enlisted, and company website.
You will find the financial statements in the respective company website.
Source of information for financial ratio analysis
- Balance Sheet
- Income Statement
- Cash flow statement
- Retained earnings statement
- Company website
Types of Financial Ratio
Different types of financial ratio serve different purposes. As an integral part of financial statement analysis, it qualifies different aspects of a business organization. It measures a business’s performance from a different point of views. Liquidity ratios measure the capability of pay-off the short term and long term (when if becomes due in a short time) debt of a company. Activity ratios measure how much time a company spends to convert its fixed assets to liquid assets. Debt ratios measure how much capability a company has to pay back its long-term debt. Profitability ratios measure how efficiently the company utilizing its assets to make a profit. Market ratios measure how the investors of stock market interact against the performance of an individual business organization; basically, deal with company’s value and return.
Interpretation of Financial Ratios
Different financial ratios are interpreted through different methods. Some have benchmarks against which the calculated value is compared. Some are compared with the ratio of other companies. For example, liquidity ratio has a benchmark of 1 to be good; below one is treated as the company is in bad condition.
How Ratios are Compared?
There are two ways of comparing and evaluating the ratios of a company. Those are time series method and cross sectional method.
In Time Series Method, the information of a specific time period is taken for a single company. Then we calculate the financial ratios. Later, we check if there is any major change in the past trend. Did it fall or go up? Finally we make a decision regarding the company.
In a Cross-Functional Method, the information of a specific time period is taken. In this case, we take more than one company. We calculate ration, and finally, we compare the ratios of a company with another one.
Limitations of Ratio Analysis
Ratio analysis is a very useful tool for financial analysts. It is very easy to calculate and convenient to use. But it still has few limitations. The knowledge of limitations can give an extra advantage to utilize the ratios more accurately. So, a financial analyst must know the limitations of ratio analysis to use this tool more efficiently and effectively.
Historical Data – the ratio is calculated by using data from past dates. So, because of the changes in economic value, it gives an old result.
Approximation method – while preparing financial statements, for few cases approximation method is used. Ratios which are directly or indirectly related to those accounts may give wrong calculation. Examples are depreciation, amortizations etc.
Quantitative method – as it is a quantitative method, it ignores qualitative approach.
Reliability – ratios are calculated from financial statements. So, if any of the data is false or fabricated, then the ratio will give a false result as well. So, the reliability is dependent on the reliability of financial statements.
Information that is not in the Balance sheet – sometimes company maintains some operations that are not included in the balance sheet, for an example off-balance sheet items. In this case, the ratio gives false value as it ignores one or more inputs.
Industry Norms – while comparing, companies must come from the same industry. Companies from different industries cannot be compared.
Raw material and operating cost – sometimes 2 companies are from different geographical locations. So, the raw material cost and operating costs can be different as well. So, those ratios dependent on these variables cannot be compared efficiently.