The world of finance and economics is inherently numerical, driven by complex computations and calculations. In the background of this complexity, financial ratios emerge as invaluable tools, providing a clear snapshot of economic health and the effectiveness of current strategies. These ratios play a pivotal role in guiding decisions and shaping investment strategies. This article delves into the significance of financial ratios and their role in the economic landscape.
Explaining Financial Ratios
Financial ratios offer concise insights into financial projections without the need for entangled calculations. They simplify the evaluation of the process, allowing investors and traders to gauge the profitability of their investments and anticipate returns quickly. These ratios are generated through various computations, often facilitated by devices, software or calculators, and convey critical financial information.
Financial ratios are not isolated; they are integrated into numerous financial procedures and statements, including balance sheets, profit and loss statements, cash flow analyses and feasibility assessments.
Moreover, they can expose hidden issues or potential challenges that may not be obvious in standard financial statements or projections. Hence, a deep understanding of the fundamentals of key financial ratios is essential.
Key Financial Ratios to Master
It’s important to note that the reality of financial ratios is dynamic, adapting to the ever-evolving business landscape. Aspiring financial analysts must stay informed and updated. Nevertheless, certain core ratios have consistently proven their relevance over time. Let’s examine some of the most pivotal ones:
1. Working Capital Ratio (WCR): Balancing assets and liabilities is a critical objective for corporations to ensure profitability and avoid excessive expenses. While incurring liabilities is inevitable for businesses (e.g. input materials, vendors, credit lines and loans), it is vital to assess the assets-to-liabilities ratio. The working capital ratio provides this insight and is calculated as follows:
Working Capital Ratio = current assets / current liabilities.
A ratio of less than 1 indicates an inefficient monetary policy and potential liquidity issues. In contrast, a WCR between 1.5 and 2 suggests a solid financial position, while a ratio exceeding two may indicate inefficient asset management.
2. Return on Equity (ROE): Investors often favour the ROE ratio, as it gauges the performance of their investments and how efficiently a business manages its invested capital. Many startups rely on investments from angel investors, accelerators and funds to launch operations. Post-launch, investors monitor the ROE to assess capital growth. The formula for calculating ROE is:
ROE: Net Income / Shareholder equity
A high ROE signifies growing investments and efficient business operations.
3. Earnings Per Share Ratio (EPS)
The EPS ratio holds a significant place in stock exchanges. Companies often rely on this metric for planning public offerings, while investors use it to allocate their investments. Essentially, EPS reveals the profitability of a company’s stock and the potential earnings for shareholders. It is calculated in two ways:
EPS = Company’s net income / average outstanding shares.
EPS – (Company’s net income – Dividends to preferred shareholders) / Average outstanding shares.
Publicly traded corporations aim to boost their EPS to attract more investors, as a higher EPS translates to greater earnings for shareholders.
Conclusion
Financial ratios are indispensable tools for comprehending a company’s financial standing and monitoring investments. These ratios, derived from various measures, provide comprehensive insights and guide a company’s financial strategy. They feature prominently in financial statements and analyses, underscoring the importance of understanding and tracking them to uncover underlying financial opportunities and challenges.
