Financial ratio analysis is the calculation and comparison of ratios 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 its attractiveness as an investment.
Calculating Financial Ratios
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 within and around it.
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.
Financial ratio analysis groups the ratios into categories that 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 show the extent to which debt is used in a company’s capital structure.
- Liquidity Ratios give a picture of a company’s short-term financial situation, or solvency.
- Operational Ratios use turnover measures to show how efficient a company is in its operations and use of its assets.
- Profitability Ratios use margin analysis and show the return on sales and capital employed.
- Solvency Ratios give a picture of a company’s ability to generate cash flow and pay its financial obligations.
The Importance of Context
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.
Unique Styles of Financial Ratio Analysis
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 for individual companies. Analysts will often differ drastically in their conclusions of 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!