Introduction to Financial Ratios

Introduction to Financial Ratios

Fundamental analyst use the financial report to derive the financial ratios. Financial ratios are then use by investor to analyze the health of a company and its intrinsic value. The advantage of using financial ratio over a data reporting in the financial report are:

  1. Allow investor to organize and simplify the data provided in the financial report .
  2. Ratios could be use to measure companies operational efficiency, liquidity, stability and profitability, giving analyst more relevant information than raw financial data provided in the financial report
  3. Breakdown the financial data so that it can be standardized to compare companies with different size in same industries or sectors.
  4.  The ratios can reveal a trend  and creating benchmark in certain industries which the performance of all industry players can be compared
  5. Ratios help determine the relative strength of companies and the intrinsic value of a company

However, it is important to realize that  the financial ratios have limitations and could not use to compare different industries as financial ratio in one industry might be viewed as less than impressive in a different industry. Since financial ratios simplify the data, it sometimes miss the bigger picture. In addition, financial ratios are derived for the past data of financial statement which may somewhat obsolete while investor are more concerned about current and future information.

Basically, financial ratios can be classified into categories depending the information it provided. Here are some frequently use financial ratios:

  1. Investment Valuation Ratios – Estimate the attractiveness of a potential or existing investment and get an idea of its intrinsic value.
  2. Profitability Indicator Ratios -Reveal how well the company utilized its resources in generating profit and shareholder value. It can be used to analyze the effectiveness of a company using its resources to generate ‘profit’ for a company and its shareholder
  3. Operating Performance Ratios -Give insight into the company’s management performance during the period being measured. It reveal the efficiency and effectiveness of a company using its resources to generate ‘revenue’ and increase shareholder equity
  4. Liquidity Measurement Ratios – measure a company’s ability to pay off its short-term debt obligations. It is used to analyze the short term risk of a company and  company’s financial position in a good shape to fund and operate its business in future.
  5. Cash Flow Indicator Ratios – Reveal how much cash is being generated and the safety net that it provides to the company. It can be use to analyze the financial health and performance of a company.
  6. Financial Leverage Ratios –  reveal the company’s overall debt load as well as its mix of equity and debt. It can be used to determine the overall level of financial risk a company and its shareholders face.

Despite all the positive uses of financial ratios, it is emphasize that investor to know the limitations of ratios and approach the ratio analysis with a degree of caution. Additional information is necessary for decision making. Nonetheless, financial ratios are still a great tool for fundamental analyst to use to analyze the attractiveness of an investment.

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