FINANCIAL RATIOS: ANALYSING A COMPANY'S HEALTH

Financial ratios are essential tools for investors, shareholders, and analysts to assess a company's financial health and performance. By extracting key figures from financial statements like the balance sheet and income statement, these ratios offer a standardized way to compare companies, track trends, and make informed investment decisions. 

Key Types of Financial Ratios

Financial ratios can be broadly grouped into several categories, each providing unique insights into a company’s operations and financial position:

Category	What It Measures	Common Ratios & Formulas
Liquidity Ratios	Ability to meet short term obligations	Current Ratio = Current Assets / Current Liabilities Quick Ratio = (Current Assets - Inventory) / Current Liabilities
Leverage Ratios	Degree of financial risk and debt usage	Debt-to-Equity Ratio = Total Debt / Shareholders’ Equity
Profitability Ratios	Ability to generate profits	Gross Margin = Gross Profit / Net Sales Operating Margin = Operating Income /
Category	What It Measures	Common Ratios & Formulas
		Net Sales Return on Assets (ROA) = Net Income / Total Assets Return on Equity (ROE) = Net Income / Total Equity
Efficiency/Activity Ratios	How efficiently assets are used	Inventory Turnover, Receivables Turnover, Asset Turnover
Valuation/Market Ratios	Market perception and stock valuation	Price-to-Earnings (P/E) Ratio, Earnings Per Share (EPS), Market-to-Book Ratio

Why Use Financial Ratios?

• Comparability: Ratios provide a common ground for comparing companies across industries and regions, helping investors identify strengths and weaknesses.

• Trend Analysis: Reviewing ratios over time reveals trends in a company’s performance, such as improving profitability or rising debt levels.

• Issue Identification: Ratios can highlight financial issues early, such as liquidity constraints or declining efficiency, prompting timely corrective action.

• Decision Support: Investors and management use ratios to make decisions about investing, lending, or operational changes. Limitations of Financial Ratios

• Context Matters: A ratio on its own provides limited insight. It’s most useful when compared to industry peers or the company’s own historical performance.

• Complexity and Overload: There are dozens of ratios, but research shows that a handful of key ratios often provide most of the actionable information. Overanalyzing can lead to confusion or inaction.

• Accounting Differences: Variations in accounting policies can affect comparability.

• Snapshot in Time: Ratios are based on past data and may not capture current or future developments.

Examples of Important Financial Ratios

• Current Ratio: Indicates short-term liquidity. A higher ratio suggests better ability to meet current obligations, but extremely high values may indicate inefficient use of assets.

• Debt-to-Equity Ratio: Measures leverage and risk. A high ratio means more debt relative to equity, which can be risky if not managed carefully. The ideal ratio varies by industry.

• Gross Margin & Operating Margin: Show how efficiently a company turns sales into profits.

• Return on Equity (ROE): Reveals how effectively management is using shareholders’ funds to generate profit.

Best Practices in Ratio Analysis

• Compare ratios to industry averages and direct competitors for meaningful insights.

• Analyze both recent trends and point-in-time data.

• Focus on a core set of ratios relevant to your investment or business goals.

• Use ratios as a starting point for deeper investigation, not as the sole basis for decisions.

In summary: Financial ratios are powerful tools for evaluating a company's financial health, but they must be used thoughtfully and in context. They help identify strengths, weaknesses, and trends, but should be complemented with qualitative analysis and industry knowledge for sound decision-making.