A Ratio is a comparison between two things. For example, we can compare boys to girls in a class; or apple to oranges in a field and so on.
If in a class we have 60 people of which 40 boys and 20 girls then the ratio of boys to girls is two. In other words, we take the total numbers of boys (40) and divide it by the total number of girls (20) and that is how we get the Ratio of 2. This relation can be expressed in the form of a number (2) or as a percentage (200%).
Financial Ratios help us to read and interpret the main financial statements. Indeed, some ratios’ main aim is to understand the risks of any organization (such as Liquidity Ratios). Other ratios will help us to assess whether stakeholders (overall organization) or shareholders (equity side of the organization) are getting enough return on the money invested in the business. Yet some other ratios will help us in the assessment or valuation of a company. In other words, they help us to answer to many questions (Is the company too risky? Is the company paying enough return on the money invested? Is the company worth buying? Is the company efficiently managed?). Financial Ratios are a simple but powerful tool to read the financial statements as quickly and accurately as possible. There are five sets of ratios used in Finance:
1. Profitability ratios
Profitability is the ability of any business to produce “earnings.” The Financial Statement, which tells us whether, a company is making profits or not is the Income Statement (or Profit and Loss Statement). In order to understand if a business is making profits we have to look at its Net Profit Line also called “bottom line” since we always find it as last item showed on this statement.
To assess profitability we have to look at the main profitability ratios. Those ratios establish a relationship between different items on the Income Statement. On the other hand the profitability ratios also establish a relationship between items that we can find on the Income Statement (such as Operating Profit and Net Profit) with items that are instead found on the Balance Sheet.
2. Liquidity Ratios
Liquidity is the ability of any business to repay its obligations in the short-term. In other words, when companies are not able to meet the obligations with their suppliers, those are considered liquidity issues. More often companies fail to achieve long-term results due to a lack of liquidity. Indeed, many organizations prefer to use their cash to buy assets that will produce earnings in the long run. This makes perfect sense, although companies have to make sure also to hold some investments, which are more liquid. In short, those investments, which will be easily converted into, cash (such as Cash & Cash Equivalents, Short-Term Investments, Accounts Receivable and so on). Liquidity assessments are very important to understand whether a company is creditworthy or not. For example, if you are going to rely on a supplier, you may want to know if this supplier will be in business in the next future and how reliable it is. Assume that you order some products for your business and suddenly you find out that your supplier is not able to fulfill the order although you already paid for it. To avoid such a risk the Liquidity Ratios can be a useful ally.
The Current Assets Section of the Balance Sheet is the place to look at if we want to know how liquid an organization is. Indeed, the Current Assets are those that will be converted into cash within one accounting cycle (one year). Therefore, we can assume that current assets will help the company to pay short-term obligations and be less risky in the short term. In addition Current Assets are listed on the Balance Sheet from most liquid (cash) to least liquid (Prepaid Expenses). For such reasons you see on the balance sheet listed under current assets, Cash – Cash Equivalents, Short-Term Investments, Accounts Receivable, Inventories, and Prepaid Expenses.
3. Leverage Ratios
A company’s assets can be financed in two ways, either through debt or through equity. Indeed, the accounting equation states that Assets equal Liabilities (obligations/debts) plus Equity (Shareholders’ Capital). When an organization buys any assets, those assets will generate future profits. On the other hand, to buy more assets a company can contract more debt and therefore increase the leverage. Leverage is good until a certain extent. In fact, while we want to take advantage of debt (since it is cheaper than Equity) there is a point over which the amount of contracted debt becomes too risky. The aim of any organization is to find its optimal capital structure. In short, the amount of Debt and Equity that brings major benefits.
To assess the level of leverage of a company we have to look at its balance sheet. The aim is to understand whether the organization is using an optimal capital structure. How? Through the main Leverage/Solvency Ratios. The aim is to understand if the company will survive in the long run.
4. Efficiency Ratios
When it comes to business organizations, efficiency means the ability to produce earnings by using the current assets the company has at its disposal. In other words, when a company manages well its current assets, automatically becomes more efficient in the short-term. This happens because the liquidity of the business increases and therefore the company can afford to make more long-term investments thanks to its short-term liquidity as well.
To assess Efficiency we have to look at both Income Statement and Balance Sheet. Indeed, the Efficiency Ratios help us in establishing a relationship between those two statements and understand if the company is well managed.
5. Valuation Ratios
Valuation is a very tricky part in finance. Indeed, valuing a company means assessing how much that is worth. Valuing is so hard since the resources a company has are organized in a way for which it becomes very difficult to determine the final value. In addition, we have the human capital aspect that is also very difficult to assess. For such reason, valuation can be considered more of an art than a science.
The Valuations Ratios help us in determining the value of any organizations. Those are not meant to be absolute measures, but just a way to see how valuable a company is.