A financial ratio can be defined as a comparative magnitude of two selected statistical values taken from the financial statements of a business enterprise. Being used in accounting very often, numerous standard ratios are used for evaluation of the overall financial condition of an organization or corporation. These financial ratios might be used by the managers of a firm, creditors of a firm, and current and potential shareholders of a firm. Moreover, these financial ratios are also used by security analysts to contrast the strengths and weaknesses of various companies.
The main sources used to calculate financial ratio include balance sheet, cash flow statement, income statement, and the statement of retained earnings. The data of these sources is based on the accounting methods and standards used by the organization.
Financial ratios are, undoubtedly, helpful in measuring numerous aspects of a business and form a vital part of the financial analysis. The financial ratios help in comparisons between companies, industries, between different time spans for a single company, and between a company and its industry average.
However, ratios are meaningless until they are benchmarked by some standards, past performance or another company for instance. It is, therefore, difficult to compare the ratios of firms in different industries experiencing distinctive risks, competition, and capital requirements.
Financial ratios are useful indicators of a firm’s performance and financial situation. Most ratios can be calculated from information provided by the financial statements. Financial ratios can be used to analyze trends and to compare the firm’s financials to those of other firms. In some cases, ratio analysis can predict future bankruptcy. Financial ratios can be classified according to the information they provide. The following types of ratios are frequently used:
The ratios tend to be most meaningful when they are used to compare organizations within the same broad industry, or when they are used to make inferences about changes in a particular organization’s structure over time. For ratios to be useful and meaningful, they must be:
- Calculated using reliable, accurate financial information
- Calculated consistently from period to period
- Used in comparison to internal benchmarks and goals
- Used in comparison to other companies in the same industry
- Viewed both at a single point in time and as an indication of broad trends and issues over time
- Carefully interpreted in the proper context, considering there are many other important factors and indicators involved in assessing performance.
- A reference point is needed. To be meaningful, most ratios must be compared to historical values of the same firm, the firm’s forecasts, or ratios of similar firms.
- Most ratios by themselves are not highly meaningful. They should be viewed as indicators, with several of them combined to paint a picture of the firm’s situation.
- Year-end values may not be representative. Certain account balances that are used to calculate ratios may increase or decrease at the end of the accounting period because of seasonal factors. Such changes may distort the value of the ratio. Average values should be used when they are available.
- Ratios are subject to the limitations of accounting methods. Different accounting choices may result in significantly different ratio values.