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Financial ratio

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Financial ratios are formed from two or more numbers taken from the financial statements of businesses. The numbers may be taken from the Balance sheet or the Income statement and combined in any number of combinations. Rarely are numbers taken from the Statement of Retained Earnings or Cash flow statement.

They are used by

  • debt issuers for analysing credit risk. They may be stipulated in the debt covenants for determining cause for default.
  • business insiders for evaluating performance of people (employee stock options) or projects, and by
  • stock pickers using fundamental analysis who use past performance to judge management and predict future performance.

The ratios quantify many aspects of the business, but they should not be used in isolation from the financials. Rather, they should be an integral part of financial statement analysis. The results of a ratio give rise to the question "why?". Further analysis is needed to answer. The ratios allow for comparisons

  • between companies,
  • between industries,
  • between different time periods of one company and
  • between a company and the industry average.

It is dangerous to compare the ratios of businesses in different industries, which face different risks, different fixed asset structures, and different competition.

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