For most of us, accounting is not the easiest subject to understand, and often the terminologies used in accounting are part of the problem. For instance, financial ratios, this sound very complicated, but in fact, it is not, it is simply averages of business.
There will be a time when you are in college or university, you‘ll face financial ratios in your coursework and assignments. However, for some students these financial ratios are a nightmare, but if understood clearly these are very simple.
“Financial ratios” are the tools that have been applied to measure a company’s performance for as long as modern capital markets have been around. These are calculated from current year numbers and then compare to previous years, other companies, the industry, or even the economy to judge the performance of the company.
The key areas of focus of the financial ratios are company’s income statements (Profit and Loss statements), balance sheet, cash flow and change in equity statements which discloses the entity stability, solvency, liquidity and profitability.
Hence, top four key ratios for evaluating the financial performance of the company are;
Profitability ratios assess the company’s capability to yield income as compared to its all expenses incurred during a specific period of time.
In financial analysis, profitability ratios are very popular metrics. Some of examples include, net profit margins, gross profit margin, return on capital employed and return on equity.
Similarly, screening and testing company’s liquidity is necessary step for analysing a company. Liquidity ratios assert the company’s ability to turn short-term assets into cash to cover its debts. Analysts use these ratios frequently to determine whether a company is going to survive in future or not. Some of the examples are current ratio and quick ratio.
These ratios are used to analyse the attractiveness of an investment in a company. The idea is that by using these ratios, investors can gain an understanding of how cheap or expensive a company’s shares are as compared to other companies. Some of the examples are Price/Earnings ratio, DPS and EPS.
Gearing/Leverage ratios are widely used in a multinational corporation, where lots of funds are borrowed. This financial ratio compares the owner’s equity (or capital) to its borrowed funds.
The higher a company’s degree of gearing, the more the company is considered risky. Some of the examples include debt/equity ratio, interest coverage and debt ratio.
Despite its usefulness, financial ratios also have some disadvantages. Firstly, financial ratios are subject to varying accounting estimates and policies. This impairs comparability and limits the efficacy of ratio analysis.
Furthermore, as financial ratios are sensitive to change in accounting standards, they are susceptible to frauds. Thirdly, inflation can cause distortion in the financial statements and hence its ratios which can be misleading if measuring performance of the company.
Finally, financial ratios are based on historical figures; therefore they can only indicate past performance accurately.