Interpreting Financial Ratios - Financial Management

A financial ratio is a relationship that indicates something about a company’s activities, such as the ratio between current assets and current liabilities or between its accounts receivable and its annual sales. Financial ratios enable an analyst to make a comparison of a company’s financial condition over time or in relation to other firms. Ratios essentially standardize various elements of financial data for differences in the size of a series of financial data when making comparisons over time or between firms.

For example, the total profits of IBM normally are many times those of Apple Computer, because IBM is a much larger firm than Apple. By computing a ratio such as net profits divided by total assets, the relative performance of the two firms can be assessed more accurately. Successful financial ratio analysis requires that an analyst keep in mind the following points:

  • Any discussion of financial ratios is likely to include only a representative sample of possible ratios. Many other ratios can be developed to provide additional insights. In some industries, such as banking, analysts use special ratios unique to the activities of the firms in those industries.
  • Financial ratios are only “flags” indicating potential areas of strength or weakness. A thorough analysis requires the examination of other data as well.
  • Frequently a financial ratio must be dissected to discover its true meaning. For example, a low ratio may be caused by either a low numerator or a high denominator. Good financial analysts examine both the numerator and the denominator before drawing any conclusions.
  • A financial ratio is meaningful only when it is compared with some standard, such as an industry ratio trend, a ratio trend for the specific firm being analyzed, or a stated management objective.
  • When financial ratios are used to compare one firm with another, it is important to remember that differences in accounting techniques may result in substantial differences in financial ratios. Failure to consider this may lead to incorrect
    conclusions.

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