Introduction
Ratio analysis has always been one of the most important components of financial analysis and decision making. A good financial manager must understand the importance of financial ratios and how to use them properly. This document will explain how to calculate, interpret, and use financial ratios.
What are Financial Ratios?
Financial ratios are numerical values derived from financial statements that help analysts evaluate a company’s performance and financial position. There are a variety of financial ratios, each of which has its own unique purpose, or “insight” into the company’s activities. A few of the most commonly used financial ratios include liquid ratio, debt-to-equity ratio, profitability ratio, and efficiency ratio.
Calculating Financial Ratios
Ratios are calculated by dividing one accounting number by another. For example, the debt-to-equity ratio is calculated by dividing total liabilities by total equity.
Interpreting Financial Ratios
Once the financial ratio has been calculated, the analyst must then interpret the results. Generally, it is important to create a benchmark for comparison purposes. For example, the industry average for the debt-to-equity ratio can be used as a benchmark for comparison. If a company’s debt-to-equity ratio is higher than the industry average, then this could indicate that the company is more risky than its peers.
Using Financial Ratios
Now that the analyst has calculated and interpreted the financial ratio, it is important to use the result to make an informed decision. For example, if a company has an abnormally high debt-to-equity ratio, then this may indicate that the company is overly leveraged and may be at risk of defaulting on its debt. The analyst should consider this risk when evaluating any potential investment in the company.
Conclusion
Financial ratios are a powerful tool for financial analysis and decision making. Analysts must understand how to properly calculate, interpret, and use financial ratios to stay ahead of the competition and make informed decisions. With the right tools, financial ratios can be used to effectively evaluate the performance and financial position of any company.
