Importance and interpretation of financial ratios

Written by admin on June 9th, 2011

When firms look for maximizing their value, they compare their performance with that of other firms in the same industry and evaluate the trends of the firm’s financial position over time. Financial statement analysis helps managers predict future earnings, dividends and free cash flow. Analysts use financial ratios to derive important information about the relationships between individual values in the financial statements and identify problem areas and opportunities within a firm. On the other hand, investors use financial statements to derive safe conclusions about a firm’s relative performance over time, and make informed investment decisions.

Financial ratios are classified into five major categories that highlight a firm’s (1) liquidity, (2) efficiency, (3) financial leverage, (4) profitability and (5) value.

(1) Liquidity

Liquidity ratios provide an indication of a firm’s short term financial situation expressing the extent to which a firm is able to pay off its debt as it comes due over the next year. The major liquidity ratios are:

Current ratio: it is the most commonly used measure of short term solvency, as it provides an indication of the extent to which the company can cover the short term claims of its creditors by assets that are expected to be liquidated quickly.
Quick ratio:  it measures the ability of a firm to use relatively liquid current assets such as cash and account receivable to cover its current liabilities.
Cash ratio: it further refines current ratio and quick ratio by relating a firm’s cash and short-term marketable securities to its current liabilities.
Receivable Turnover: it measures how often the firm’s receivables turn over, that is how often they are collected. If the average collection period implies a fast turnover, it means that the firm gets the funds to pay off its own liabilities on time.
Inventory Turnover: it measures how many times a firm’s inventory is sold and replaced over a period. High inventory turnover typically represents a zero return on investment.

(2) Efficiency

Efficiency ratios provide an indication of a firm’s receivables and how efficiently it uses and controls its assets, pays its suppliers, and uses its equity using borrowed funds. The major efficiency ratios are:

Total asset turnover: it measures the effectiveness of the use of all the firm’s assets.
Fixed Assets turnover: it measures how effectively the firm uses its plant and equipment.
Gross Profit Margin: it provides an indication of the basic cost structure of the firm. By analyzing gross profit margin over time relative to a comparable industry figure investors can understand the firm’s relative cost-price position.
Return on Total Capital: it relates the firm’s earnings to all the capital involved such as debt, common stocks and preferred stocks indicating the firm’s return on all the capital employed.

(3) Financial Leverage

Financial leverage ratios provide an indication of a firm’s long-term solvency. The major financial leverage ratios are:

Debt ratio: it measures the percentage of funds provided by sources other than equity to cover a firm’s liabilities
Debt- to-Equity ratio: it measures the economic risk that a firm undertakes. A higher proportion of debt compared to equity implies higher economic risk, increasing the probability of defaulting on the debt.

(4) Profitability

Profitability ratios provide useful information about the joint effects of liquidity, operating performance and debt management on operating results. The major profitability ratios are:

Profit margin on sales ratio: it measures the profit per dollar on sales. In relative valuation, if two firms have same sales figures, operating costs and earnings before income and taxes (EBIT), but one firm uses more debt than the other, it means that it has higher interest charges that decrease net income and consequently lower profit margin on sales. Therefore, profit margin on sales ratio is a very important financial ratio in relative valuation.
Return on Total Assets (ROA): it measures the return on net income on total assets after interest and taxes, providing, an indication on how efficient a firm is at using its assets to generate earnings.
Return on Common Equity (ROE): it measures a firm’s profitability by revealing how much profit a firm generates with the invested funds by its shareholders.

(5) Value

Market value ratios relate a firm’s stock price to earnings, cash flow and book price per share to provide an indication of what investors think about the firm’s past performance and future prospects. The major market value ratios are:

Price/Earnings (P/E) ratio: it provides an indication of how much investors are willing to pay per dollar of a firm’s reported profits. When a firm’s P/E ratio is lower than the industry average, the firm is considered as being riskier than most firms in the industry, for having relatively poor growth prospects.
Price/Cash Flow (P/CF) ratio: it measures the investor’s expectations of a firm’s prospect financial health.
Market/ Book (M/B) ratio: it provides an indication of how much investors are willing to pay for a dollar of a firm’s book value.

Benchmarking Financial Ratios

In Finance, numbers in isolation have little meaning. For instance, knowing that a firm reports a net income of 0,000 conveys little information about the firm’s financial strength and business practices unless we know the sales figures that generated this income and the capital committed. Because financial ratios on a stand-alone basis convey little importance, they are benchmarked against aggregate economy, the industry that the firm operates in and its historical performance using time-series analysis.

Comparing a firm to the aggregate economy is important because economic fluctuations can influence a firm’s profitability. For instance, during a recession, firms normally face a decrease in their profit margin, while during a major business expansion they are more likely to increase their profit margin. Such comparisons enable investors to understand how firms react to the business cycle and to estimate their future performance during subsequent business cycles.

Comparing a firm to the industry averages in perhaps the most important part of relative valuation. Different industries influence the firms within them differently. For instance, the industry effect is stronger for industries with homogenous products such as steel, rubber, and wood products because all firms in this industry experience correlated shifts in demand and employ similar technology and production processes. For instance, it is reasonable to expect a decline in the sales of a steel firm during a recession. However, it makes more investment-sense to compare how severe was this decline relative to the other steel firms of the industry.

When performing a financial ratio analysis to compare a firm to the industry averages, investors do not use the average (mean) industry value, particularly if there is a wide variation among firms in the industry. It is more accurate to conduct a cross-sectional analysis and compare the firm to a subset of industry firms that share the same size and characteristics. Besides, a cross-sectional analysis alleviates the problems that arise when investors need to evaluate a multi-industry firm against the financial ratios of a single industry. By constructing composite industry average ratios investors, in effect, use the weighted-average ratios based on the proportion of firm sales derived from each industry.

Comparing a firm’s historical performance using time-series analysis is useful because it provides investors with information whether the firm is progressing or declining. Typically, investors calculate a five- or ten-year average ratio taking into consideration the time-series trend of relative financial ratios compared to the industry and the economy as to derive safe conclusions about a firm’s relative performance over time.

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