Financial Ratio
by Clemens Werkmeister
Financial ratios as a managerial tool
Ratios or indicators provide concise information about a company or its business. They are used in different ways as a managerial tool, in planning and control, or performance measurement, and in communication to different stakeholders, among others. This results in a broad variety of ratios, financial and non-financial, … Given their availability and high standardization, ratios based on financial statements (financial ratios) are very common.
Financial analysts often use rules of dumb („Golden rules“) for „good“ financial ratios. But since there exist large differences between industries or strategies, usually the rules of dumb are not applied to all companies in the same way. Sometimes, extreme financial ratios are even the core of the competitive advantage of a company. However, a comparison of financial ratios to industry averages, other benchmarks, or a look at financial ratio time series can call attention to trends and outliers which require an in-depth analysis and explanation by management.
The following overview shows important financial ratios:
Short-term Liquidity Ratios
- compare current assets or parts of them to current liabilities
- as recognized and reported in the balance sheet
- in order to gauge the likelihood that companies meet their current financial obligations.
- Only the Operating cash ratio considers for non-balance-sheet financial obligations (e.g. wages, interest payments, leasing and rental payments), as long as they are part of the cash flows from operating activities.
1. 2. 3. 4.
Debt Ratios
- inform about the capital structure (the mix of debt and equity financing) and the financial leverage and risk associated with it
- compare a company's financial resources from operations to its interest obligations (based on income (accruals) or based on cash)
- in order to indicate the ability of a company to meet its debt obligations
5. 6. 7. 8.
Asset Efficiency or Operating Ratios
- measure the use of specific or total assets through a company
- as length of time required for assets to be used or replaced
- assume that the higher the turnover ratios the more efficient the assets are used
- provide information about specific management capabilities, e.g.
- the credit policy and its credit-granting and credit-collecting activities
- the inventory policy and the ability to forecast the needs of customers
10. 11. 12.
Profitability or Return Ratios
- relate income to sales or assets
- inform about the results achieved with sales or assets
- inform about the results achieved with shareholders' equity
- relate profitability to critical success factors (profitability drivers)
14. 15. 16. (simplified version) 17. 23.
Stockholder Ratios
- relate income to sales or assets
- inform about the payout strategy
- include market share price in the analysis
18. 19. 20. 21. 22.
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see:
Kennzahlen
Accounting exercises
Rich et al.: Cornerstones of Financial and Managerial Accounting. South-Western Cengage 2012.