Financial Ratios And Their Function

A financial ratio is an objective, arithmetic ratio of two chosen financial numbers taken directly from the financial statements of an enterprise. Often used in accounting, a financial ratio gauges the health of a company or other entity by comparing it to similar organizations of similar size and age. In some ways, financial ratios help business owners and managers compare apples to apples. By comparing a company’s financial data, they hope to get a picture of its potential profitability and that of its peers.

The composition of a company’s balance sheet and its overall financial ratios are not all that important to investors. Their attention instead is directed toward the assets and liabilities that compose the balance sheet. As such, they seek to obtain company information that gives them an idea of the current value of the company’s equity as compared to its total assets. For this reason, financial ratios of equity and assets can be quite different from one company to another, even over short time periods.

Good corporate finance principles require that a company determine the nature of its market, its competition, and its entry and exit costs before determining its operating margins, its capacity for generating cash and its debt to earnings ration. A company’s balance sheet, therefore, provides the most accurate picture of the health of the firm. The purpose of providing a company with a balance sheet is to provide adequate information to meet at least the basic requirements of fair valuation of the firm. However, because a company must maintain minimum required financial ratios throughout its operations, the actual performance of the company can vary significantly from period to period. To address this issue, business managers and investors use financial ratios of income statement to forecast the health of the firm based on information provided in the balance sheet.

Financial ratios of income statement can be used by business owners and managers to track the performance of the company. The purpose of using these ratios is to provide enough information to make sound decisions about the short-term and long-term health of the business. Unfortunately, there are a number of situations where financial ratios will not provide enough information to make sound decisions. When this situation arises, small business owners and managers must use other techniques to evaluate and improve the performance of the company. One technique that many small business owners use is to create an internal management team to perform an in-depth analysis of the business and create actionable plans regarding key priorities.

Good measures of financial strength depend on the definition of “good,” and on the use of metrics to quantify it. Good financial ratios of income statement rely on the ability of the reporting entity to determine both the market value of the firm and the weighted average cost of capital employed. Market value is defined as a market price of all tangible assets of a firm that can be obtained from transactions done in open market. The weighted average cost of capital, which is an economic concept that effectively measures the value of capital over time, is used to calculate the financial ratios. When a firm is growing, its financial ratios are likely to be higher because of the increased value of equity and retained earnings per share. Conversely, when the firm is slowing down, its financial ratios decrease due to the decline in retained earnings per share and equity.

Some companies use financial ratios (like profit and loss per Share) and some use balance sheet ratios (like current and long-term debt and assets). It is important for a manager to understand whether they are looking at a fundamental measurement such as income from operations or a financial ratio such as EBIT. A fundamental measure such as income from operations is based on the underlying receipts and payments of the business. A financial ratio, however, is more difficult to calculate because it is not easy to ascertain the measurement of intrinsic value. Many companies use both measures to calculate their financial ratios.