Over the years, analysts have developed number of financial ratios to analyze company’s strength and weakness by reading and comparing line items of financial statements. The main purpose for which a company prepares financial statements is to provide information to interested parties. These interested users include investors, shareholders, lenders, creditors, government and credit rating agencies.
To analyze the financial statements, investors and analysts prepare financial ratios. Ratio analysis involves comparing different relevant numbers of financial statements and studying the relationship.
For instance in case of current ratio, we compare current assets to current liabilities. If current ratio is 2 or 2:1, it means we have twice as much current assets to take care of short term obligations.
Every company prepare and publish its financial statements for stakeholders. Three most commonly used financial statements to analyze company’s strength and weakness are followings:
These techniques of analyzing company’s strength and weakness is part of fundamental analysis. In this article, we will show you all the important financial ratios available to analyze a company and why to use these financial ratios.
Why to use financial ratios
Anyone can read company’s financial statements, but it’s not how to read, it’s about how to analyze and interpret line items of these statements by comparing with previous years and different standards. Financial ratios are one of the best tool that was developed to start analyzing these statements. These tools will give you real insight into the numbers reported by the company in its income statement, balance sheet and statement of cash flow.
By analyzing company’s financial ratios, you will get answer to following questions;
- does the business make profitable use of the capital available to it?
- is the business efficiently using its resources?
- how well the business is equipped to meet its current obligations?
- how the capital is contributed to the business? Out of total how much is contributed by owners and how much is contributed by outsiders?
- what return the organization is able to generate on shareholders investment?
Financial ratios are considered as backbone of fundamental analysis. You can compare one company with another by using these ratios as it gives you a common basis for comparison instead of solely emphasizing a single period’s line items.
Financial ratios can be divided in number of ways. To analyze business performance and financial position of an organization, we have grouped it to following categories:
- Profitability indicator
- Activity or operating performance
- Liquidity measurement
Financial ratios to know company’s profitability
Management’s performance are tracked more closely as earnings or profitability. To analyze company’s profitability, following ratios can help you know how the management has performed during the period.
All these tools are used to compare profit margin at different point of time with revenue from business to find out how profitable the company is. These financial ratios measure how much profit a company is getting from its resources and how well the company is doing at making money .
Company’s efficiency can be measured by assessing the liquidity position and by figuring out how well a company is managing its affairs. It determines the ability of a company to generate cash and to pay its obligations when they come due.
Following important ratios can be used to assess management’s liquidity:
- Acid test or Quick
Activity or operating performance indicators
Activity ratios are used to know how company is using its assets to generate money. To know company’s efficiency, you can use following financial tools:
Turnover ratio indicates how much a company gets out of its assets. These are also known as efficiency ratios as they indicates how well a company is managing its resources.
To evaluate a company which has debt, you can use following two solvency analysis tool to find out how company is covering its cost of debt and will it be be able to survive in long run.
Coverage ratios is a measure of company’s ability to meet a particular obligations such as interest, rent and any other fixed obligations.
If the company has a high interest coverage ratio, then company is generating enough profit to repay its debt obligations. This means higher the interest coverage is better, as it has ability to meet its longer-term obligations.
Finding value of a stock
To find value of a stock and the actual price to buy and sell, you can take help of following valuation ratios. For instance, price to book (P/B) compares company’s current stock market price to its book value. A higher price to book value indicates, investors are paying more for the company’s assets. A stock with high price to book value is called growth stock. Similarly if its less, then investors are not paying more for the book value of the company. A stock with less price to book is called value stock.
These financial ratios can help you to find all information you need to analyze a financial statement. Understanding its impact can give you greater confidence in your investment decision.