Ratios are used by financial analysts to determine the “health” and performance of a company since they paint an instant picture of the situation in a format that can easily be compared to the results for other companies without consideration for factors such as different currencies and different sizes.

They can however present a useless figure if that figure is taken into consideration out of context or without reliable figures to be compared with. In other words, a single ratio will not provide enough information to make a judgment about a company. One must consider additional data to make these judgments. The source of this information might be from comparing the ratios to the industry average or past company performance. Three useful comparisons are historical, bench marks and cross-sectional comparisons. For instance, a 10% annual growth rate for a given company might seem positive, but when compared to a history of 50% annual growth over the past three years takes on a whole new meaning.

Similarly, the 10% figure for one company this year compared to a 40% growth experienced by two other companies in the same industry shows that even though there has been growth, it is dwarfed by the performance of their competitors.

It is therefore important when reviewing each aspect of financial performance to highlight any significant changes in performance, either compared to previous years or compared to a competitor. Highlighting significant changes enables the focus on key events or major factors that may have important implications for the company.

Finally, one ought to look at financial performance within the context of the political, business and economic environment in which the business operates.

Following are some examples of the strengths and weaknesses of using financial ratios to determine the performance of a company:

Currencies : The result of a ratio is independent of the currency in question enabling comparison of companies reporting financials in different currencies.
Novartis and Merck are currently the two largest pharmaceutical companies. They report in CHF and US$ respectively so ratios enable fair comparison between them.
GAAP : Different accounting regulations cause companies to report financials in different ways. This hinders the comparison of ratios that are reported under a different GAAP.

Company Policy : Companies adhere to accounting principles throughout the lifetime of the company but these differ from company to company. Unless this is accounted for when calculating ratios, an unfair picture will be presented. This emphasises the importance of referring to the audited notes to the financial statements.
Danone (France) and Nestle (Switzerland), multinational food groups reported profit margin ratios of 4.6% and 5.6% respectively in 1996. However Nestle’s cash-flow margin was lower (14% vs. 14.4%). Nestle only began to capitalise and amortize goodwill in 1995, reporting a small amortisation charge in 1996. Danone’s policy of capitalising intangible assets and amortizing them over their useful lives caused their 1996 profits to be lower by 865 million French Francs.
Size : Reporting profits as a figure is misleading. The performance of a company may be masked behind huge figures reported for profit.
ROI ratios can give the low-down about how much of the profit declared is actually translated to earnings for the shareholders.
Context : A ratio taken out of the context of political, economic or other exceptional factors can be misleading.
· Jack Daniels Distillery must carry its “stock” in casks for twelve years before it can be sold, making stock turnover ratios useless as a measure of efficiency.
· Taken out of context, a decrease in Free Cash Flow is alarming. However when seen in the light of an increased capital expenditure in that year especially for a company experiencing growth, is still a healthy sign.
Concise presentation: Ratios provide a clear picture of the financial information of a company that is otherwise unclear from raw financial data.
Ratios from the categories for Gearing, Efficiency, Profitability and Liquidity, for instance provide an instant picture of the performance of that company.
This can also prove to be a disadvantage as mentioned previously by masking relevant factors that can not be presented in figures.
Now-notorious internet companies presented remarkable figures for share prices and Price-Earning ratio but carefully hid Profitability and liquidity figures.
Consistency : Not all ratios are computed in the same way. Sometimes a ratio is referred to in the same way but calculated differently. It is therefore important to cite the method used for every ratio calculated when the results are presented. Similarly, when a ratio is encountered in an annual report, it pays to recalculate that ratio using the method one is accustomed to for consistency’s sake.

The more common financial ratios are the following :

These represent the ability of a company to meet short-term financial obligations as they fall due. The higher the ratios, the higher the liquidity of the company. Capital Structure
The proportion of non-equity capital used to finance the company is determined by these ratios. The higher the ratios, the higher the proportion of assets financed by non-shareholder parties. Debt Service Coverage
These refer to the ability of a company to pay back interest payments that arise from debt that is not equity. Profitability
Duh! is a tempting note here but considering recent tides on the financial shores an explanation is in order. This measures the ability of a company to generate [revenues in relation to activity that has taken place or the resources utilised Efficiency

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