Companies prepare financial statements to provide a deeper understanding of what is occurring in their business, both operationally and financially. Analyzing these statements helps companies identify issues before they become serious. Analyzing also identifies trends which may lead companies to take action, for example, adjusting their sales strategy. Financial ratios enable companies to go into deeper analysis. They also facilitate performance comparisons between companies in their industry and across industries.
A financial ratio is the number that results when you divide one accounting number by another. For example, the debt to equity ratio is a financial ratio. It is calculated by dividing total debt by the sum of debt plus equity. A financial ratio shows one financial measure in relationship to another. Although ratio calculation is relatively straightforward, it is not just the base number that matters. It is the comparison of that number to historical numbers and industry averages that matters most.
Debt-to-Equity Ratio Example
A company’s debt-to-equity ratio is 0.5. Comparison to the company’s past three years shows that this ratio is usually 0.3 for the company. The industry average is 0.55. This increase in the debt-to-equity ratio could indicate management’s decision to increase the company’s debt load to better leverage the company’s assets and equity and more closely match the industry.
Financial ratios are comparative values. They allow business owners and managers to compare financial performance by converting information into a comparative format. Companies are unable to compare basic numbers because the raw data provides no context for understanding if the data is high or low or “good” or “bad”.
Accounts Receivables Turnover Example
Company A has $400,000 in accounts receivable outstanding for an average of 30 days and Company B has $500,000 in receivables outstanding for an average of 40 days. From the raw data it appears that Company A has better collections than Company B. However, if Company A has $1.6 million in revenue per year but Company B has $5 million in revenue per year that assumption changes. Analysis of the accounts receivable turnover ratio, which compares the net sales to the average balance of all receivables, would quickly demonstrate this.
Financial ratio comparison is most typically done within a company’s industry. Although each industry has an average for each financial ratio, the numbers that comprise that average can vary widely. Comparing across industries increases variability and therefore, the ratio’s relevance. Capital intensive industries including manufacturing and telecom often have higher debt-related ratios while service businesses including financial services or personal services have significantly lower ratios. However, if a company is considering making an acquisition of a company in a related but separate industry, a cross-industry comparison may be worthwhile.
- Sacramento State: Financial Management – Principles and Practice [http://www.csus.edu/indiv/k/kuhlej/finance 101/1.docx]
- Accounting Coach: Financial Ratios Based on the Balance Sheet [http://www.accountingcoach.com/online-accounting-course/03Xpg02.html#financial-ratios-1c]