Types of Ratios

The commonly used financial ratios are of essentially two kinds. The first kind summarizes some aspect of the firm's "financial condition" at a point in time - the point at which a balance sheet has been prepared. We call these balance sheet ratios, quite appropriately, because both the numerator and denominator in each ratio come directly from the balance sheet. The second kind of ratio summarizes some aspect of a firm's performance over a period of time, usually a year. These ratios are called either income statement or income statement/balance sheet ratios. Income statement ratios compare one "flow" item from the income statement with another flow item from the income statement. Income statement/balance sheet ratios compare a flow (income statement) item in the numerator with a "stock" (balance sheet) item in the denominator. Comparing a flow item with a stock item poses a potential problem for the analyst. We run the risk of a possible mismatch of variables. The stock item, being a snapshot taken from the balance sheet, may not be representative of how this variable looked over the period during which the flow occurred. (Would a photograph of you taken at midnight on New Year's Eve be representative of how you look, on average?) Therefore, where appropriate, we may need to use an "average" balance sheet figure in the denominator of an income statement/balance sheet ratio to make the denominator more representative of the entire period. (We will have more to say on this later.)

Benchmarking - measuring a company's operations and performance against those of world-class firms - can be applied to ratio analysis. Therefore, in addition to comparing a firm's ratios to industry averages over time, you may also want to compare the firm's ratios to those of a "benchmark," or world-class, competitor in the firm's industry.

Additionally, we can further subdivide our financial ratios into five distinct types: liquidity, financial leverage (or debt), coverage, activity, and profitability ratios. No one ratio gives us sufficient information by which to judge the financial condition and performance of the firm. Only when we analyze a group of ratios are we able to make reasonable judgments. We must be sure to take into account any seasonal character of a business.

Underlying trends may be assessed only through a comparison of raw figures and ratios at the same time of year. We should not compare a December 31 balance sheet with a May 31 balance sheet but rather compare December 31 with December 31.

Although the number of financial ratios that might be compared increases geometrically with the amount of financial data, only the more important ratios are considered in this chapter. Actually, the ratios needed to assess the financial condition and performance of a company are relatively few.