Financial Ratios as Tools for Evaluating Corporate Performance

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Financial ratios are widely used by investors, creditors and management when evaluating corporate performance. Different financial ratios of measuring various aspects of company operations are of distinct importance to different users. Investors likely worry most about the valuation of their investments as reflected in valuation ratios. Lenders need to be assured of a company's financial strength as shown in various debt ratios. Management may only reward itself based on its management effectiveness as measured by ratios on asset utilization and investment return. Financial ratios are useful tools to track corporate performance over time and make comparisons among companies.

Profitability Ratios

Profitability ratios are the most basic financial ratios relevant to all users. In general, profits exist on three levels based on their associated costs. Although gross profit considers only costs of goods sold, operating profit also takes into account other costs from operations. The total net profit encompasses all costs, including accounting charges and any nonoperating expenses. Profitability ratios are essentially sales margins, the percentage of relevant profit over total sales. Any ratio analysis requires not only calculation but also interpretation. For profitability ratios, useful interpretation should lead to the understanding of how various costs are controlled relative to a certain amount of sales.

Financial Strength

Although profitability is of general interest for all parties, lenders and other creditors are more interested in a company's financial strength. Financial ratios designed for assessing financial strength include liquidity ratios and leverage ratios. Liquidity ratios concern a company's ability to meet short-term obligations. The most commonly used liquidity ratio is the current ratio, which measures the amount of current assets against current liabilities. To avoid potential liquidity issues, a company must have enough current assets readily convertible to cash to cover any current liability payments when due. Leverage ratios deal with the relative proportions between debt and equity. The lower a debt-to-equity ratio is, the less financially leveraged a company is, and the greater its financial strength.

Management Effectiveness

Management effectiveness is about how well management has used a company's resources to generate sales revenue and earn investment returns. For example, the amount of sales can be measured against total assets or fixed assets to see how productive management is in using a particular type of asset. Such measures are often referred to as asset utilization ratios. Since any asset is a form of investment, profits provided by asset deployment show management effectiveness in earning investment returns. Ratios on investment returns include return on assets and return on equity, which compare net income against total assets and shareholder equity, respectively.

Valuation Ratios

Corporate performance, especially that of publicly traded companies, eventually is reflected in a company's valuation by its investors. When valuing a public company, often through its stock, investors often compare stock price to a range of economic performances of the company, from earnings and sales to book value and cash flows. The stronger those performance measures are, the more investors may value the company's stock by placing higher prices on its shares. Two widely reported valuation ratios when quoting company stocks are price-to-earnings ratio, or P/E ration, and price-to-book ratio. Investors' interpretation of such ratios can be subjective. For example, a high P/E may indicate overvaluation to some investors but growth potential to others.

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