Key financial ratios

Key financial ratios - are used to evaluate the financial performance of the company. Financial ratios are used when we know the structure of the assets, liabilities and equity from the balance sheet and when we know sales and expenses from the income statement.

The top tip for every investor, manager or any other who is interested in financial ratios is - one factor or financial ratio cannot show enough information to determine how well going the company is. Only one ratio cannot affect the decision of the investor, because it is always needed to compare the same ratio during the period of time to see the changes of it and it is needed to find other ratios that represent the same situation or gives additional information that is useful for the investor.

It is also useful to know, that the ratios as a whole must be taken seriously and should be assessed carefully, by analyzing a group of the ratios, the changes of the ratio in a period, by comparing the ratios with other companies in the same geographical region, segment or strategy of the companies.

Usually four main groups of the ratios are used when describing key financial ratios: it is liquidity ratios, activity, leverage ratios and profitability ratios. Every group explain different sector of the company, so they cannot be compared to each other, but they can be as additional ones, giving extra information. The ratios in the same group can be compared to each other and decisions to improve some group can be made when analyzing the structure of the financial statements.

The first - liquidity group is the smallest and includes only two ratios: current ratio and quick ratio. This group helps to find out how the company is able to meet its short term obligations and how it is able to remain solvent. In order to improve this ratio it is needed to increase the amount of long term debt, sell more additional stock or resign unproductive fixed assets.

The second group is activity ratios. It includes such ratios as: Inventory turnover, receivables turnover, average collection period, payable turnover, working capital turnover, fixed assets turnover, over and under trading ratios. This group of ratios shows how well the assets invested are used in the company.

Third group of ratios is leverage ratios. It reflects the long term solvency of the company and shows how well the long term debt is used in the company. This group includes such ratios as: debt to equity ratio, equity ratio, ratio of fixed assets to shareholders funds, ratio of current assets to shareholders funds, interest coverage ratio, capital gearing ratio, over and under capitalization.

Fourth and the last group are profitability ratios. It includes: Gross profit ratio, net profit ratio, operating ratio, expense ratio, return on shareholder’s investment or net worth, return on equity capital (ROE), return on assets (ROA), return on capital employed (ROCE), dividend yield ratio, dividend payout ratio, Earnings Per Share (EPS) ratio and Price to earnings ratio. This group is mainly focused on the efficiency of the company and it shows how profitable the operations of the company are.

For the investor it is useful to have a calculator - a spreadsheet with formulas included, which would calculate key financial ratios of the company when he types in the balance sheet and income statement data in it. It would be a useful tool in analyzing ratios and following them in a period of time. This calculator could be used for other companies as well, so the results of every company’s key financial ratios would be representative and comparable.