Why are financial ratios critical in financial analysis?
Financial ratios are useful tools for investors to better analyze financial results and trends over time. These ratios can also be used to provide key indicators of organizational performance, making it possible to identify which companies are outperforming their peers. Managers can also use financial ratios to pinpoint strengths and weaknesses of their businesses in order to devise effective strategies and initiatives.
What are the main uses of financial ratios?
Financial ratios are widely used in financial analysis to determine how companies are performing internally and/or relative to one another. These ratios generally fall within one of four types of measurements: profitability, liquidity, solvency, and valuation. Understanding and applying ratios from all of these categories can enable investors to make smarter stock purchases and potentially avoid hefty losses.
What financial ratio measures risk?
Several financial ratios can be used to measure a company’s risk level, particularly in relationship to servicing debts and other obligations. These financial ratios include the debt-to-capital ratio, the debt-to-equity (D/E) ratio, the interest coverage ratio, and the degree of combined leverage (DCL). Analyzing risk is useful for both bankers deciding whether to grant loans as well as private equity investors picking companies to invest in.
What is solvency vs. liquidity?
Solvency and liquidity are both terms that are related to a business’ financial health. Solvent companies are those that own more in assets than they owe in debt, which means they have a greater capacity to meet long-term financial commitments. Companies that are adequately liquid can meet their short-term financial commitments and are able to sell assets to swiftly raise cash if need be. Healthy companies are those that are both solvent and possess adequate liquidity.
Dividend Payout Ratio
The dividend payout ratio represents the percentage of a company’s net income that was paid out to shareholders as dividends. While older companies pay out a larger portion of their earnings to shareholders, young businesses may have a low or even 0% payout ratio. As dividend payouts can also vary between industries, they are most useful as a comparison tool for companies in the same sector.
Standard deviation is a measure of variation of a dataset relative to its mean. In finance, this statistic can be used to measure an asset’s relative riskiness. Standard deviation is flawed in that it treats all outliers and extreme values as risk, even if the source of the uncertainty is in an investor's favor.
Compound Annual Growth Rate (CAGR)
The compound annual growth rate (CAGR) refers to the annual growth rate of an investment over time, assuming any profits are reinvested at the end of each period of its life span. Although it isn’t a true return rate, CAGR is considered one of the most accurate means of calculating and determining returns for anything that can increase or decrease in value over time. However, CAGR ignores volatility and does not account for an investor adding or withdrawing funds from a portfolio, among other limitations.
Discounted Cash Flow (DCF)
Discounted cash flow (DCF) is a model for estimating how much an investment will be worth based on its expected future cash flows. If an investment’s DCF is calculated as being greater than its present cost, then it may result in positive returns. Because investors can only estimate future cash flows and the value of investments, DCF has the potential to be inaccurate.
Cost of Goods Sold (COGS)
Cost of goods sold (COGS) is the total amount a company paid to produce and sell its products. COGS includes the cost of materials and labor directly used to create a good, excluding indirect expenses. This metric is listed on a company’s financial statements and is subtracted from its revenues to calculate its gross profit.
Price Elasticity of Demand
Price elasticity of demand is a measure of how sensitive the demand or supply for a good is relative to its price. If a good is elastic, then its demand or supply should increase or decrease as its price goes down or up, respectively. If a good is inelastic, then its demand or supply should have little to no effect on its price.
Debt-to-Equity (D/E) Ratio
The debt-to-equity (D/E) ratio is used to both indicate how much financial leverage a company has and compare its total liabilities to its shareholder equity. Companies that have a high D/E ratio generally represent riskier investments. Although the D/E ratio is an important metric in corporate finance, it’s less useful as a comparison tool, given that the ideal level of debt will vary from one industry group to another.
Earnings Per Share (EPS)
Earnings per share (EPS) is the value of a company's net income per the outstanding share of its common stock. In other words, EPS measures how much money a company earns for each share, which makes it an effective metric for estimating profitability. Companies with high EPS are also considered more valuable to investors, given their higher profits relative to their share price.
Explore Financial Ratios
Demonstrating Value. "Financial Ratio Analysis." URL: https://www.demonstratingvalue.org/resources/financial-ratio-analysis