Financial ratios are calculated using a combination of line items from a company's financial statements. Most come from the income statement and balance sheet, but some also require the cash flow statement. They are used by owners and investors for a variety of purposes, including credit analysis, forecasting, benchmarking and relative valuations, and can be used to analyze a company's stocks and bonds. They are a simple way to summarize a company's financial position, including relative to its peers, and allow you to remove some of the subjectivity involved from financial analysis by applying quantitative methods.
Mechanics of Calculating Financial Ratios
A spreadsheet is a useful tool to use to calculate financial ratios. First, input the company's financial statements into the spreadsheet. Then, set up a separate worksheet or section for the ratio analysis. Enter in each financial ratio's formula by linking directly to the related line items within the financial statements. This allows you to easily update the financial analysis in future years if necessary, because with the ratios already input as formulas, newly inputted financial results will flow through into the financial ratio section. Also, entering the ratios as formulas make it easier to perform quality control.
Customize For Analysis Type
Customize the ratio analysis based on the type of analysis you are performing by selecting the most relevant financial ratios. For example, if you are performing a credit analysis, the ratio analysis should contain more cash flow coverage and leverage ratios. A solvency analysis would focus more on short-term liquidity and working capital. Any general financial analysis should contain ratios measuring the company's growth, leverage, profitability, asset and liability turnover, and liquidity. Profitability ratios include return on assets and return on equity. Turnover ratios, such as inventory turnover and accounts payable turnover, provide information regarding a company's efficiency.
Analyze financial ratios for trends. This requires calculating financial ratios using at least 3 to 5 years of the company's historical financial results. Look for general upward or downward trends in profitability and returns. If no clear trend is evident, this indicates that the company's performance is erratic, which indicates higher risk. Leave space available in the spreadsheet under each financial ratio so that you can insert the formulas for cumulative growth and compound annual growth rates, useful in identifying trends. Trends are particularly relevant when you are attempting to forecast future financial performance.
Financial benchmarking involves comparing your subject company's financial ratios to those of a peer group, which can include the company's competitors. Benchmarking is especially useful for conducting relative valuations. The peer group selected should consist of companies that are highly comparable to your subject company in terms of size, growth, profitability and line of business. It makes little sense to compare the results of a small, unprofitable manufacturer with those of a large, fast-growing and highly profitable software company.