A financial ratio can be well defined as a comparative magnitude of two selected statistical values taken from the financial statements of a business enterprise. Being used in accounting very often, numerous standard ratios are used for evaluation of the overall financial condition of an organization or corporation. These financial ratios might be used by the managers of a firm, creditors of a firm, and current and potential shareholders of a firm. Moreover, these financial ratios are also used by security analysts to contrast the strengths and weaknesses of various companies.
These financial ratios can be expressed in decimal as well as percentage values. For example, ratios higher than 1, like the P/E ratio, are expressed in decimals. On the contrary, ratios lower than 1, like the earnings yield ratio, are expressed in percentages.
The main sources used to calculate financial ratio include balance sheet, cash flow statement, income statement, and the statement of retained earnings. The data of these sources is based on the accounting methods and standards used by the organization.
Financial ratios are, undoubtedly, helpful in measuring numerous aspects of a business and form a vital part of the financial analysis. The financial ratios help in comparisons between companies, industries, between different time spans for a single company, and between a company and its industry average. However, these financial ratios can be categorized as follows:
The liquidity ratio is helpful in quantifying the availability of cash in a business to pay back its debts.
- Activity ratios (Asset management ratios)
The activity ratio is helpful in quantifying the time taken by a firm to convert its non-cash assets into cash-assets.
The debt ratio is helpful in assessing the ability of a firm to pay back long-term debts.
The profitability ratio is helpful in quantifying the use of a firm’s assets and its control over the expenses thereby producing a desirable return rate.
The market ratio helps in quantifying the response of investor on owning and the cost of issuing stock of a company.
However, ratios are meaningless until they are benchmarked by some standards, past performance or another company for instance. It is, therefore, difficult to compare the ratios of firms in different industries experiencing distinctive risks, competition, and capital requirements.