‘Financial Ratios’ an important financial computation in finance are mathematical calculations which are used to analyse a company’s financial statements, performance, position and efficiency. These financial ratios are a great tool for potential investors, creditors and various others stakeholders of the company which provide valuable insights into the company’s financial health, profitability and potential for long term growth and success.
A financial ratio is a quantitative representation of a company’s financial performance, derived from its financial statements.
These financial ratios are computed by taking into consideration the various financial parameters from the financial statements of the business.
It provides a comparative measure to assess liquidity, profitability, solvency position, efficiency and market valuation.
The above mentioned definition encapsulates the ultimate purpose of financial ratios which is to transform raw financial data into meaningful insights for decision making. It is a great tool for the internal management as well as the external stakeholders of the company to reach conclusions and make the best of their investments.
Financial ratios are computations derived from financial statements of the company by complex mathematical calculations. There are many financial ratios, each providing an accurate financial figure and data.
Key Importance of Financial Ratios:
Estimating The Financial Performance:
Financial ratios provide a standardised way to compare a company’s performance in due course of time or with its potential competitors. These financial ratios help potential investors, financial analysts, internal management, external stakeholders, the government to evaluate the company’s ability to generate earnings, manage assets & liabilities and create shareholder value in the long run. It turns out to be a guiding factor for individuals carrying a potential stake in the company.
Data Driven:
Financial ratios create a great data driven document. Individuals seeking clarity about the financial statements of the company gain great insights through financial ratios, they get the data driven financial figures of the company’s performance and expected future forecasts.
Identifying Strength And Weaknesses:
By analysing different type of ratios such as liquidity, profitability and solvency ratio, financial analysts and various stakeholders can identify a company’s strengths and weaknesses. This data driven financial information can help managers and internal management address areas of strategic improvement and make informed systematic decisions about the future investments and capital resource allocation.
Strategic Future Forecasting:
Financial ratios can be used to forecast a company’s future performance identifying and analysing the current trends and patterns prevalent in the financial data. This historic data is critically analysed by financial analysts and a budgeted forecast is prepared for the next financial year.
Strategic Comparison:
Financial ratio analysis allows for comparison with industry peers, enabling companies’ to benchmark their performance against their competitors. This helps to analyse areas where a company maybe laging behind or excelling compared to its peer.
Detecting Accounting Irregularities:
Financial ratio analysis can help auditors and regulators detect potential accounting irregularities such as fraudulent practices or manipulation of financial statements. By analysing financial ratios they can identify accounting abnormalities that may indicate a suspicious activity, for example: unusually high or low profit margins, excessive use of balance sheet financing or unusual changes in the asset valuations.
Evaluating Creditworthiness:
Lenders use financial ratio analysis to value a company’s creditworthiness and determine whether to extent credit or not. By analysing financial ratios such as the debt to equity ratio and current ratio, potential financers can analyse a company’s ability to meet its financial obligations and repay its debts.
Identify Dividend Payment Capacity:
Financial ratio such as the dividend payout ratio help investors understand a company’s ability to pay dividends to its shareholders. It is an important parameter for investors who rely on dividend income as a source of return on their investment (ROI).
Analysing Capital Structure:
Financial ratios like the debt to equity ratio help investors understand the companies’ capital structure & assets and evaluate its level of risk. This information is important for investors who want to understand the company’s funding strategy, risk profile, the mechanism in which operates, etc
Evaluating Management Efficiency:
Financial resource such as the Return on Equity (ROE) and Return on Assets (ROA) help evaluate the effectiveness and efficiency of management in generating profit from those assets and investments. Potential investors can reach conclusions whether these assets are optimally used or not. This information is important for investors who want to assess the performance of management and make informed decisions about their investment strategies, providing insights for strategic decision making. Financial Ratio Analysis provides valuable insights that help to take strategic decisions such as investments in new projects, acquisitions or divestitures.
By analysing financial ratios companies’ can identify areas where they can improve their operations, strategically reduce cost and increase the profitability significantly. This information can help companies’ make informed decisions about where to allocate their resources and invest their time and money.
In conclusion, financial ratio analysis is a powerful tool that can be used for a variety of purposes which is just beyond evaluating a company’s financial performance. It can help identify accounting irregularities, assess the creditworthiness, identify the dividend payment capacity of a company, analyse the capital structure, evaluate management efficiency and provide useful financial insights for strategic decision making for its internal management and external stakeholders.
