Why understand financial ratios.
Many knowledgeable economists will tell you "ratios will rarely give you a definite answer." And I must to say that they are right. But What is often much more important, the ratios help you to put the right Questions.
What not only managers and financial investors most pursue in the firm’s economy is the profitability area.
The ratios be able to answer, for example, to bellow mentioned questions. As a base for it will be statement of profit and loss, balance sheet, also the number of shares issued will be given to us:
- What is the return of investment of shareholders?
- Look for the ROE – (return on equity) indicator – the higher its value, the shareholders are likely to be more satisfied.
- Does the company Use its assets sufficiently effectively?
- Look for the ROA (return on assets) indicator – the higher the number, the more efficient is the use company asset.
- Does the company Achieve enough profit margins?
- Look for the indicator ROS (return on sales) profitability indicator of sales. It Shows what profit the company achieves per €1 sales. The higher the number, the better.
- Have the company under control its costs from operating activities?
- The High values of these indicators indicate a waste of company capital.
- How successful is the company in dividend policy?
- Here we monitor the profitability of the company for one share. A Larger number indicates a better result. In Addition, there is the possibility of legal adjustment of the profit-setting for the financial year.
An Important area for society from the long-term perspective is the risk of obtaining funds and its liquidity (how quickly the company is able to meet its obligations). Here, we should ask questions like:
- Does the company have sufficient resources to ensure its functioning?
- Apparently The first thing we should concentrate on is the working capital of the company. The lower its value, the bigger problems we can expect. Feel sure that it is for one of the things that the banker will consistently follow in your establishment.
- Is the company able to meet its short-term commitments (i.e. pay it in the time)?
- Is the company able to repay interest to its creditors from loans and other loans?
- DSCR (debt service coverage ratio) is followed by interest cover. The higher is, the more creditors can be at rest (and of course, the company too)
- Is the company's capital structure optimal?
- Here apparently we will be watching not only WAAC ( Weighted Average Cost of Capital). This is nothing else, then sum of the costs of each type of capital, taking into account the structure of own funds.
Dealing with the current assets
It is another area that should be monitored. It relates directly to the issue of raising funds.
- Can the company work effectively with its claims?
- What is the ratio between collection of receivables and payments for company's liabilities? Is there a large disproportion that can be dangerous for society? The Progress of the receivables turnover period is a signal of the company's customer status. If this time has been prolonged, beware. There's something wrong with your customers. And This development also threatens your financial position directly.
- How much money does the company have in its inventory?
- Too long stock turnover times generally do not indicate economical management of the inventory area. The funds are thus bound inefficiently and disrupt the CF company. In This way, financial stability can also be compromised, but also the company's existence.
- How effectively does the company use its assets?
- How much sales is produced by each crown invested in assets by the company? Here we will track the asset turnover period. A Higher value indicates a more efficient use of resources embedded in assets.
Do you plan to trade your business in public markets? Then It is worth to deal with questions like:
- What is the difference between a market and book value of company?
- This will, the M/B (market value for the accounting ratio) or P/B (ratio of the price to book value)-the ratio of the market book value of bonds, and the book value can be measured in different ways, one of which may be amount of a core capital. The higher the value of the indicator, the better the company probably prospers.
- How large dividends the company pays?
- The percentage of net profit distributions in the form of dividends is higher, the less the company reinvests in its development.
- How does the market perceive the company from the perspective of future developments?
- Here we will be interested by P/E (Price/equity). The higher the value, the greater the satisfaction of shareholders, and more attention is paid to investors. The company's Assessment of the market from the perspective of its future development is better.
In any case, regarding the ratios, is necessary to realize following:
The Company cannot be particularly good in all indicators
- A Certain indicator value does not tell you whether a business is good or bad at any given time.
- E.g. the high value of normal liquidity can point to good liquidity, but also to a large volume of outstanding claims.
- It Is very difficult to obtain comparative criteria as each company is different in its structure.
- Indicators can be deliberately adjusted as well. They are calculated from data which are static in its essence.
- E.g. Leasing can improve asset utilization indicators, but can also influence the reported earnings, all in a compliance with the law.