In the past few chapters, we have become familiar with how to read financial statements, and now, our concentration will be on how to analyse them. The concept of financial ratios was established by Benjamin Graham, famously known as the pioneer of fundamental analysis. With this tool, companies can examine the outcomes, compare yearly figures and measure up against others in their respective industry.
To understand financial ratios, we must be familiar with specific characteristics. This requires using data from financial statements to calculate its numerical value.
The financial ratio of a company alone tells us very little. Take Ambuja Cements Limited, for example; they have a 15% profit margin, but it’s impossible to tell if it’s the best without more context.
Once you have calculated Ultratech Cement’s profit margin at 12%, it is logical to compare this with Ambuja Cements Limited to see which one is more profitable. However, simply computing the ratio does not always give a complete picture; analysis of the ratio (by comparison to another similar-sized organisation or by tracking its historical trend) is essential to gain meaningful insights.
You should remember that accounting policies can differ between companies and through various financial years. Thus, a detailed analyst must take this into consideration, adjusting any data where necessary before calculating the financial ratio.
– Financial Ratios
Financial ratios can be divided into categories such as liquidity ratios, profitability ratios, activity ratios and leverage ratios. These classifications offer a broad overview of a company’s performance.
The Profitability ratios allow the analyst to gauge a company’s effectiveness in generating profits. This reveals the competitiveness of the management, which is essential for business growth and distributing dividends to shareholders. Therefore, it is imperative to take account of a company’s profitability.
Leverage ratios, alternatively referred to as solvency or gearing ratios, assess the ability of a company to fulfil its long-term financial obligations. This type of measure takes into account the extent to which debt has been used to support firm operations and growth. By understanding a concern’s ability to pay its bills and liabilities, these ratios give us an idea of the sustainability of its activity in the future.
Valuation ratios compare a company’s stock price with either its profitability or its overall value to get an idea of how expensive or inexpensive it is trading. This helps to determine whether the current share price is seen as high or low by providing a comparison between the cost of the security and the benefits of holding the stock.
The Operating Ratios, also known as ‘Activity Ratios’, measure the effectiveness with which a business can convert its assets (both current and noncurrent) into revenue. This ratio gives us an insight into the efficiency of the company’s management. As such, these ratios are sometimes referred to as ‘Management Ratios’.
Ratios in any category offer insight into the financial status of a company. A good example is the ‘Profitability Ratio’, which measures the efficiency of a business and is derived from the ‘Operating Ratio’. Because specific ratios can overlap, it can be hard to classify them accurately. As such, ratios tend to be ‘loosely’ divided.