A financial ratio is a comparative degree of two preferred arithmetical values taken from an organization’s fiscal statements. They become habitually used in accounting, to ascertain overall financial state of an organization. Before investing in a company, investors need to scrutinize clearly on the companies ratios so as to know whether the company is the best to invest. There are many ratios that an investor puts in mind before choosing a company in which to be a shareholder.
The profitability ratios are indispensable in that they measure the returns of a company to its sales, assets or even the equities. They include net profit margin, return on assets and return on equity. The net profit margin signifies the rate of profits from transactions and other revenues. The liquidity measures are another class of ratios, which function in indicating the ability of a firm to funds its daily procedures and satisfy the commitments as they occur. They include current ratio and net working capital. Leverage ratios are other key ratios in an organization. It shows the amount of debt used by a company, to fund its operations and resources. They also become referred to as the gearing ratios. In this category lies the debt to equity ratio and the coverage ratios.
When deciding to invest in a company, it is necessary to understand the financial ratios of the company. The following is the analysis of these ratios that are better used by an investor to ascertain the company in which to invest. The price to earnings (P/E) ratio is commonly known as the valuation ratio. This ratio to a appreciable extent outlines the market’s optimism for the growth of the company. It measures the price remunerated for a share relative to the yearly net income produced in the by the firm for each share. A higher price to earning ratio means that investors are paying more for each unit of net income; and; therefore, the price is relatively expensive to when the price for earning ratio was lower. The P/E ratios also illustrate the existing investor claim for a company share. Therefore, by relating the price and earning per share of a company, an investor can analyze the market’s stock survey of a company and its shares comparative to the returns the company is essentially generating.
Debt to equity is another ratio that an investor needs to check on when selecting the company in which to invest in. This ratio indicates the relative proportion of shareholders equity and debt used to finance a company’s assets. It is sometimes also known as the leverage ratio since it gauges the level to which a company is financed through debts. Investors usually put this ratio into consideration as it helps them acquire a relative measure of how the company is alleged from a menace outlook. A superior debt to equity result shows that the company has a reasonably higher obligation to forfeit fixed interest modifications.
Operating profit margin ratio measures the ability of a company to generate revenues while at the same time managing expenses. It is computed by dividing operating profits by the sales. The higher the operating profit the better as it shows that a company is able to manage the expenses incurred with the high revenues it gains; hence the investor can decide to have investment portfolios with the company. The net profit margin though having some similarities with the operating profit ratio is also a significant ratio that an investor uses in gauging the investment worth of a company. It measures the percentage of sales the company gets to pay as dividends or retain as earnings. A small net profit margin is viewed as risky. Both of these ratios can be generated from the company’s financial statements.
Limitation of financial ratios
Financial ratios are mainly based on reported accounting numbers in corporate, financial statements. They, therefore, contain all the accounting limitation of these numbers including the flexibility and prejudice of the Generally Accepted Accounting Principles (GAAPs) . Lee also argues that the ratios pose a disadvantage in that they attempt to standardize reported accounting information, in such a way that the analyst and resolution maker can find it easier to assess the financial performance. The standardization of this scenery to a greater extent tends to mask the effect of size in corporate business.
The ratios are consequent from past information while businesses take into version the future prospects . He argues that the past reporting provides guiding principle into marking trends towards better and deprived performances in the company. A highly visible disadvantage of using ratios is that they put into consideration only the information that is computed on the financial statements. They, therefore, do not put into consideration the qualitative and quantitative information that is not depicted on the statements, such as the excellent employee performances.