Experienced traders and investors measure their success using numbers, which are their primary indicators of success or failure. These figures are a result of complex mathematical calculations, which tell a lot about an investment portfolio or a company’s performance.
Besides the mere profits and losses that use simple calculations, financial ratios are a little bit more complicated. However, they measure overall performance levels and tell managers a lot about an organisation’s target and financial well-being.
Let’s take a look at some of the important ratios and what they tell you.
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Financial Ratios Defined
Judging a company’s performance based on basic numbers like how much profit they make or comparing revenue with expenses is a surficial approach. Calculating financial ratios includes how much money was invested, how much profit each $1 generates, how the company’s fixtures and equipment contribute to generating returns and how profitability compares to current debts and expenses.
The combination of the above might seem complicated. However, they can unveil major business problems or positive signals. For example, a company may generate consistent profits back-to-back, but it is easy to overlook the company’s liabilities, working capital, and interest-rate payables.
Therefore, successful organisations keep these ratios on display and calculate them every time they talk about profit or loss, whereas a quick snap at these numbers tells a lot about real financial performance.
The Importance of Financial Ratios
Companies drive much of their decisions and strategies based on performance ratios, whether they need to embark on a new sales campaign, liquidate some of their assets, cut some expenses, or increase their investments to utilise their capital. These decisions are fact-based and rely on numbers to avoid vague statements or planning.
Therefore, these figures are used together with periodic financial statements and reports, like balance sheets, cash flow statements, and profit and loss statements, in order to draw a clear picture of the organisation.
Also, shareholders and investors use these ratios to understand how their investments are doing and how much money they may expect in returns or dividends if a company distribute such.
How to Calculate Financial Ratios
Financial ratios can be calculated using a dedicated program integrated with the company’s systems, which reads basic figures like revenues, expenses, current assets and liabilities to automatically generate ratios and analysis about best practices and how to address negative results.
Also, you can calculate these ratios using a simple calculator or Excel sheet using formulas to avoid dealing with complicated software. Here are the top ratios that most organisations keep track of.
EPS = company’s net income / average outstanding shares.
EPS = (company’s net income – dividends to preferred shareholders) / average outstanding shares.
This ratio tells the investor how much their capital is growing in comparison to each share they own in the company. Public companies offer their shares to secondary markets where traders buy and sell stakes in different companies, and it is a more straightforward way to calculate how much revenue each share brings.
Private entities are treated differently because their shares are not publicly traded, and only a handful of companies trade them to private markets.
However, this ratio is used when a company plans to go public, so it calculates the value of each share and uses this information to attract investors to buy stakes. Also, investors use the EPS ratio to make their decision if they want to invest in this company’s stock during IPO application.
Working Capital Ratio
Working Capital Ratio = current assets / current liabilities.
This ratio indicates how efficient are the company’s resources, fixtures, equipment and workforce, in short, working capital. Needless to say, companies are better off when their assets outweigh their liabilities, like expenses, interest rates, taxes and dividend payables.
Therefore, the WCR ratio is used to compare current assets to current liabilities and use the resulting number to make business decisions.
Organisations cannot avoid liabilities like loans, credits, vendors and suppliers. However, it is crucial to keep track of them and not overburden the company with these liabilities.
As a general rule, the WCR resulting score needs to be between 1 and 2 to indicate good financial performance, meaning that the company is managing its assets and liability efficiently and keeping a balanced liquidity ratio in store.
However, having a ratio of more than 2 is not good because it means that a company is handling its assets efficiently and has many unproductive assets in-house.
Return on Equity
ROE = Net Income / Shareholder Equity
Return on equity is one of the most important ratios, which tells the investors how much money they are generating by investing in a certain business. Naturally, the higher this ratio is, the better.
Shareholders use this figure to understand how their money is being managed and if the company is running a positive financial policy to generate more profits. Small companies and start-ups use this figure to attract investors and venture capitalists to invest in their companies.
Conclusion
Financial ratios are crucial business indicators that tell a lot about business performances, gaps or well-being based on one figure.
Ratio analysis is important to make informed business decisions that are fact-based, and keeping track of these numbers is crucial to understanding the company’s progress.
Investors and banks request these financial statements and ratios before they make any investment decisions and draw conclusions about a company’s potential.