Financial ratios –How to Read, Understand and Interpret

Financial ratios –A Must Carry Out Process

Whether you are a trader who wants to maximize the gains or whether you are an analyst who is just analyzing the economy or whether you are just a common man who wish to understand the pure fundamentals of any company before jumping on to investing into its stocks, you are ought to understand the financial basics known as fundamentals of the company.Such financial key figures can be summarized as financial ratios which are calculated on the basis of financial statements of the company.

This article will try to summarize the uses of financial ratios , types and method of calculation and will try to conclude on why you ought to have knowledge about it.

Uses of financial ratios

– Comparison

Financial ratios are basically used for inter firm comparison as well as with historic performance of the company itself.Financial ratios can provide a basis for comparison between firms belonging to similar or same industry, because basic fundamentals from the same industry are the same.

– Benchmark

For any industry , benchmark setting is a vital task as it will lead the organization towards financial objective attainment in an objective manner.For e.g. If manufacturing industry overall has average Gross Profit (GP) margin at 5% and competitors from the same industry have overall GP margin around 3%-5% , then the manufacturing firm under consideration will set a benchmark at 3% – 5% , which will allow them to survive the competition and thrive hard in the market.

– Trend identification

This is much peculiar use of financial ratios which will inflict the vision in the organization. The organization should keep on observing various ratios pertaining to firm, the competitors and the industry as a whole.In business , it is not abnormal to have lower revenues or losses , however the analysis of financial ratios prepares the firm to be ready for all downs and to exploit the ups of the trends.

– Identification and quantification of SWOT

Every company has its strengths , weaknesses , opportunities and threats , however the success of the company solely depends on how the company uses its strengths by exploiting its opportunities by battling with its weaknesses and threats.Financial ratios prepare the organization to battle the worst and makes it ready to exploit the better factors.

Types of ratios

Financial ratios are divided into following

– Profitability ratios

Profitability ratios are calculated to understand the profitability position , which would provide more insight on management’s performance. Profitability ratio would include

1) Gross Profit margin-

calculated as = 

This ratio is an indicator for effectiveness of management performance, while it suffers weakness that it won’t consider depreciation , interest and other costs which are very important for maintaining the business.

2) Net Profit Margin

Calculated as = 

This ratio measures overall profitability , which would yield the bottom line percentage. This ratio performs as a better tool for inter firm comparison, where stronger GP margin with weaker NP margin would be ineffective.

3) Return on assets

Calculated as = 

This ratio yields the degree of effectiveness by which the company is able to use its assets to generate its business. However, it may be disturbed by depreciation or any expenses which may arise in course of business.

4) Earnings Per Share (EPS)

Calculated as = 

This ratio actually tries to measure how much the investor will earn for rupee 1 invested in company stocks.

– Liquidity ratios

1) Current ratio

Calculated as = 

This ratio would measure the liquidity position of the company , which would estimate the company’s ability to pay off its current liabilities with its current assets.

2) Acid Test Ratio

Calculated as = 

where quick assets would be calculated as =( cash and cash equivalents + marketable securities + accounts receivables).This ratio if more than 1 , suggest too much of cash handling and if less than 1 , then suggests poor accounts receivables collection.

3) Days receivable ratio

Calculated as = 

This ratio gives out number of days for which the accounts receivables are outstanding. This figure should be ideally less than or equal to credit period granted for debtors.

– Leverage ratios

1) Debt to equity ratio

Calculated as = 

This ratio has to be between 50% to 80% ,as higher than that would indicate unsafe investment due to higher debt burden and, lower than that would decrease debt exposure.

2) Interest coverage ratio

Calculated as = 

This ratio would indicate whether the earnings of the company are sufficient enough to cover the interest payable.

– Efficiency ratios

1) Inventory holding period

Calculated as = 

This ratio would measure the number of days taken for conversion of finished product into sales.

2) Accounts receivable turnover

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This ratio measures the number of days taken for conversion of credit sales into cash.

CONCLUSION

Even though Financial ratios seems a bit of a technical tool , they are really simple to understand and analyze.They really give insight on company fundamentals which can prove as an aid for decision making with respect to investing in its stocks.

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