Lesson 4: The Financial Ratios

Financial Ratios, fundamental analysis

Financial Ratios, fundamental analysisFor ordinary investors, the task of determining the health of a listed company by looking at financial ratios may seem daunting. Yet, it does not require special training or countless hours of research. Even the novice investor can make sense of a listed company’s balance sheet, profit and loss and cash flow statement by using financial ratios.

Financial ratios are one of the most common tools of managerial decision making. A ratio is a relationship between two numbers indicating how many times the first number contains the second. These ratios simplify the process of determining the health of a listed company and make reported financial information more meaningful and useful for investors.

Financial ratio analysis is the comparison of two items in the financial statement. In this way, you can make an evaluation and interpretation of financial data that otherwise would be impossible to do taking the items separately.

One goal of the financial analysis is to identify problems that affect the company. By identifying issues early, managers can make corrections to improve company performance. Another goal equally important purpose of the financial analysis is to determine company strengths so those strengths can be enhanced and used to their highest potential.

The methods are based on tried-and-true accounting ratios, which have been around for even longer. The theory of financial ratio analysis was first popularised by Benjamin Graham who is considered by many to be the father of fundamental analysis. Benjamin Graham, who from 1928 was a professor at Columbia Business School as well as a very successful investor in his right, was mentor and teacher to Warren Buffett.

Fundamental analysis, of which financial ratio analysis is but one subset, looks at a company’s financial statements, management, health and position in the competitive landscape to determine a share price valuation. It is different from the other commonly used methods of investment analysis (quantitative analysis and technical analysis) in that it looks from the bottom-up rather than from the top down, or, in the case of technical analysis, from what the charts say.

Financial ratios are tools to help with the interpretation of results and to allow for comparison to previous years, other companies and the industry sector. Fundamental analysis and financial ratio analysis must form the basis of all investment decisions, because without knowing the exact financial position of a company you are purely speculating.

Fundamental analysis and financial ratio analysis, as you can imagine, is a pretty powerful thing and is essential for successful investing. Some people may opt for quantitative or technical analysis methods when it comes to sharemarket investing, depending upon their personalities, spare time and inclinations, but for most investors, the fundamental analysis offers a sound, intellectual framework for making informed share investment decisions.

Within the broad discipline of fundamental analysis, financial ratio analysis, in turn, offers the clearest, easiest and most logical set of indicators for a sharemarket investor. Empirical and tested evidence suggests that fundamental and ratio analysis is a powerful ally in the hands of an active and savvy investor.

In the analysis of financial statements, it is better to have a complete understanding of the different types of ratios, their calculation, and interpretation. Financial ratios can be classified into five categories as follows:

Liquidity Ratios indicate whether a company can pay off short-term debt obligations (debts due to be paid within one year) as they fall due. A higher value is desired as this indicates a greater capacity to meet debt obligations.

Solvency Ratios, also referred to as gearing ratios, measure the extent to which a company utilises debt to finance growth. These ratios give an indication of a company’s long-term solvency. While most financial experts will acknowledge that debt is a cheaper form of financing than equity, debt carries risks and investors need to be aware of the extent of this risk.

Profitability Ratios measure a company’s performance and indicate its ability to generate profits. As profits are used to fund business development and pay dividends to shareholders, a company’s profitability and how efficient it is at making profits is an essential consideration for shareholders.

Efficiency Ratios serve as a guide to critical factors concerning the use of the firm's assets, inventory, and accounts receivable collections in day-to-day operations. Asset utilisation ratios are especially important for internal monitoring concerning performance over multiple periods, serving as warning signals or benchmarks from which meaningful conclusions may be reached on operational issues.

Valuation and Growth Ratios are used by investors to determine whether the current share price of a company is high or low in relation to its real value. These ratios also help us assess if a company is cheap or expensive relative to earnings, growth prospects and dividend distributions.

In next months, I will introduce and briefly discuss a number of the more common financial ratios. It won't be an exhaustive list by any standard, but they will give you a basis in the fundamental analysis where to start for studying in deep this kind of analysis.


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