Financial ratio analysis is the calculation and comparison of ratios which
are derived from the information in a company's financial statements. The level
and historical trends of these ratios can be used to make inferences about a
company's financial condition, its operations and attractiveness as an
investment.
Financial ratios are calculated from one or more pieces of information from
a company's financial statements. For example, the "gross margin" is
the gross profit from operations divided by the total sales or revenues of a
company, expressed in percentage terms. In isolation, a financial ratio is a
useless piece of information. In context, however, a financial ratio can give a
financial analyst an excellent picture of a company's situation and the trends
that are developing.
A ratio gains utility by comparison to other data and standards. Taking our
example, a gross profit margin for a company of 25% is meaningless by itself.
If we know that this company's competitors have profit margins of 10%, we know
that it is more profitable than its industry peers which is quite favourable.
If we also know that the historical trend is upwards, for example has been
increasing steadily for the last few years, this would also be a favourable sign
that management is implementing effective business policies and strategies.
Financial ratio analysis groups the ratios into categories which tell us
about different facets of a company's finances and operations. An overview of
some of the categories of ratios is given below.
- Leverage Ratios which show the extent that debt is used in a
company's capital structure.
- Liquidity Ratios which give a picture of a company's short term
financial situation or solvency.
- Operational Ratios which use turnover measures to show how
efficient a company is in its operations and use of assets.
- Profitability Ratios which use margin analysis and show the return
on sales and capital employed.
- Solvency Ratios which give a picture of a company's ability to
generate cashflow and pay it financial obligations.
It is imperative to note the importance of the proper context for ratio
analysis. Like computer programming, financial ratio is governed by the GIGO
law of "Garbage In...Garbage Out!" A cross industry
comparison of the leverage of stable utility companies and cyclical mining
companies would be worse than useless. Examining a cyclical company's
profitability ratios over less than a full commodity or business cycle would
fail to give an accurate long-term measure of profitability. Using historical
data independent of fundamental changes in a company's situation or prospects
would predict very little about future trends. For example, the historical
ratios of a company that has undergone a merger or had a substantive change in
its technology or market position would tell very little about the prospects for
this company.
Credit analysts, those interpreting the financial ratios from the prospects
of a lender, focus on the "downside" risk since they gain none of the
upside from an improvement in operations. They pay great attention to liquidity
and leverage ratios to ascertain a company's financial risk. Equity analysts
look more to the operational and profitability ratios, to determine the future
profits that will accrue to the shareholder.
Although financial ratio analysis is well-developed and the actual ratios
are well-known, practicing financial analysts often develop their own measures
for particular industries and even individual companies. Analysts will often
differ drastically in their conclusions from the same ratio analysis.
As in all things financial, beauty is often in the eye of the beholder. It
pays to do your own work! |