Financial Ratio
Financial ratios are important values to understand the firm’s financial situation and the performance. These ratios are analyzed and calculated on the basis of financial statements provided by the firm.They are also used in comparing other firm’s financial ratios and at times it can predict bankruptcy in future. Financial ratio analysis can be considered as a quantitative analysis for analyzing the firm, with an investment prospective.
This is an important study in understanding ratios and various financial values in the statement such as income statement, cash flow statements and balance statements. When these statements are properly interpreted and analyzed, they can provide valuable information of the present business. Financial ratios are categorized according to information provided by the company such as:
- Liquid Ratios
- Ratio of asset turnover
- Ratio of financial leverage
- Profitability Ratio
- Ratio of Dividend Policies
Limitations and Use of Financial Ratios:
Financial ratios are primarily used by financial institutions, creditors, potential and current investors to evaluate firm are past performance. It also spots the present business trends and it compares the performance with the average industries. It justifies further investments in the business by identifying the weaknesses and the strengths of the business. While using financial ratios, attention should be given to some issues such as:
- Reference Point: A meaningful reference point is required which should be compared to the historical ratios of same firm as well as other firms; so as to forecast firm’s financial status.
- Indicators: Most of the ratios are not meaningful but they can be viewed as an indicator to understand the firm’s financial situation.
- Average Values: Accounting values may increase or decrease due to the seasonal factors at the end of accounting term that could divert the values; hence, average values should be preferred whenever available.
- Different Accounting Choices: Different accounting choices might calculate different values for ratios hence, appropriate method should be incorporated.
Some of the important points the investor should keep in mind while analyzing the financial status of the company are:
Company Performance: The investor should study the performance of the company over the previous years, and also the returns it has generated for the previous stakeholders.
Industry Standard: The investor should study the relative performance of the company to the industry standard that it belongs to.
Market Fluctuations: Check if the company has enough liquidity to survive the short term market fluctuations.
Working Capital: Study how the company manages its working capital.
Risks: Calculate all the possible risks before investing in the company.