FINANCIAL RATIOS- APPLICATIONS
The financial analyst needs to perform â€˜checkupsâ€™ on various aspects of a firmâ€™s financial health to evaluate a firmâ€™s financial condition and performance. A tool frequently used during these checkups is a financial ratio, or index, which relates two pieces of financial data by dividing one quantity by the other.
Analysts calculate ratios because in this way a comparison is made between two financial parameters that may prove most useful than the raw numbers by themselves. For example, suppose that a firm had a net profit figure this year of $1 million. That looks pretty profitable. But, what if the firm has $ 100 million unvested in total assets? Dividing net profit by total assets we get $ 1 M / $ 100 M= 0.01, the firmâ€™s return on total assets. The 0.01 figure means that each dollar of assets invested in the firm earned a 1 % return. A saving account provides a better return on investment than this, and with less risk. In this example the ratio proved quite informative.
But one needs to be careful and cautious in the choice and interpretation of ratios. Take inventory and divide it by additional paid-in capital and there is a ratio, but whether any meaningful interpretation of the resulting figure can be made.
The analysis of financial ratios involves two types of comparison. First, the analyst can compare a present ratio with past and expected future ratios for the same company.
The current ratio is the ratio of current assets to current liabilities for the present year which could be compared with the current ratio for the pervious year end. When financial ratios are arrayed over a period of years on a spread sheet the analyst can study the composition of change and determine whether there is an improvement or deterioration in the firmâ€™s financial condition and performance over the time period. The financial analyst is not so much concerned with one ratio at one point in time, but the ratios over a time period. Financial ratios can also be computed or projected and compared with present and past ratios.
External Comparisons and Sources of Industry Ratios
The second method comparison involves comparing the ratios of one firm will those of similar firms or with industry averages at the same point in time. Such a comparison gives insight into the relative financial conditions and performance of the firm. It also helps us identify any significant deviations from any applicable industry average or standard. Financial ratios are published for various industries in U.S. by Robert Morris Associates, Dun & Braddstreet, Prentice Hall (Almanac of Business and Industrial Financial Ratios), the Federal Trade Commission / the Securities and Exchange Commission, and by various credit agencies and trade associations. In other countries the ministries of industry of governments, confederation of industries or chambers of commerce publish such details of ratios.
Industry average ratios should not, however, be treated as targets or goals. Rather, they provide general guidelines.
The analyst should also avoid using â€œrules of thumbâ€? indiscriminately for all industries. The criterion that all companies have at least a 1.5 to 1 current ratio is inappropriate. The analysis must be in relation to the type of business in which the firm is engaged and to the firm itself. The true test of liquidity is whether a company has the ability to pay its bills on time. Many sound companies, including electric utilities, have this ability despite current ratios substantially below 1.5 to 1. It depends on the nature of the business. Failure to consider the nature of the business and the firm may lead one to misinterpret ratios. We might end up with a situation similar to one in which a student with a 3.5 grade point average from Ralphâ€™s Home Correspondence School of Cosmetology is perceived as being a better scholar than a student with a 3.4 grade point average from Harvard Law School just because one index number is higher than the other. Only by comparing the financial ratios of one firm with those of similar firms can one make a realistic judgment.
Accounting data from different companies should be standardized adjusted to achieve comparability to the extent possible. Even with standardized figures, the analyst should use caution in interpreting the comparisons.