Financial ratios are tools for interpreting financial statements to provide a basis for valuing securities and appraising financial and management performance.
A good financial analyst will build in financial ratio calculations extensively in a financial modeling exercise to enable robust analysis. Financial ratios allow a financial analyst to:
- Standardize information from financial statements across multiple financial years to allow comparison of a firm’s performance over time in a financial model.
- Standardize information from financial statements from different companies to allow an apples to apples comparison between firms of differing size in a financial model.
- Measure key relationships by relating inputs (costs) with outputs (benefits) and facilitates comparison of these relationships over time and across firms in a financial model.
In general, there are 4 kinds of financial ratios that a financial analyst will use most frequently, these are:
- Performance ratios
- Working capital ratios
- Liquidity ratios
- Solvency ratios
These 4 financial ratios allow a good financial analyst to quickly and efficiently address the following questions or concerns:
- What return is the company making on its capital investment?
- What are its profit margins?
Working capital ratios
- How quickly are debts paid?
- How many times is inventory turned?
- Can the company continue to pay its liabilities and debts?
Solvency ratios (Longer term)
- What is the level of debt in relation to other assets and to equity?
- Is the level of interest payable out of profits?
There is also an excellent financial ratio analysis template available in the Finance 3.0 forums, that allows you to calculate, analyze and compare a set of business & financial ratios to assess & measure the operating performance of your own business or businesses / stocks that you intend to invest in.
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