Use of Financial Ratios

To evaluate a firm's financial condition and performance, the financial analyst needs to perform "checkups" on various aspects of a firm's financial health. 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.

Why bother with a ratio? Why not simply look at the raw numbers themselves? We calculate ratios because in this way we get a comparison that may prove more useful than the raw numbers by themselves. For example, suppose that a firm had a net profit figure this year o: $1 million.That looks pretty profitable. But what if the firm has S200 million invested in total assets? Dividing net profit by total assets, we get $1M/$200M = 0.005, the firm's return on total assets. The 0.005 figure means that each dollar of assets invested in the firm earned a one-half percent return. A savings account provides a better return on investment than this. and with less risk. In this example, the ratio proved quite informative. But be careful. You need to be cautious in your choice and interpretation of ratios. Take inventory and divide it by additional paid-itt capital. You have a ratio, but we challenge you to come up with am meaningful interpretation of the resulting figure.

Internal Comparisons. 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 (the ratio of current assets to current liabilities) for the presen: year could be compared with the current ratio for the previous year end. When financial ratio are arrayed over a period of years (on a spreadsheet, perhaps), the analyst can study the composition of change and determine whether there has been an improvement or deterioration in the firm's financial condition and performance over time. Tn short, we are concerned no: so much with one ratio at one point in time, but rather with that ratio over time. Financial ratios can also be computed for projected, or pro forma, statements and compared with present and past ratios.

External Comparisons and Sources of Industry Ratios. The second method of comparison involves comparing the ratios of one firm with those of similar firms or with industry averages at the same point in time. Such a comparison gives insight into the relath, financial condition and performance of the firm. It also helps us identify any significant deviations from any applicable industry average (or standard). Financial ratios are published lor various industries by The Risk Management Association, Dun & Bradstreet, Prentice HaL {Almanac of Business and Industrial Financial Ratios), the Federal Trade Commission/tlv. Securities and Exchange Commission, and by various credit agencies and trade association. Industry-average ratios should not, however, be treated as targets or goals. Rather, they provide general guidelines.

The analyst should also avoid using "rules of thumb" 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 firr 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 Ralph'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.

To the extent possible, accounting data from different companies should be standardized (i.e., adjusted to achieve comparability). Apples cannot be compared with oranges. Even with standardized figures, the analyst should use caution in interpreting the comparisons.