As explained in the article “Understanding Financial Statements In 5 Easy Steps”, financial ratios are main tools to analyse the financial strength of a firm. They quantify many aspects of a business and are an integral part of the financial statement analysis.
1. Why calculate financial ratios?
Financial ratios are useful to investors and management in analysing the outcome of strategic decisions, such as an increase of market share by selling more licenses or an increase of profit by increasing selling prices or decreasing expenses. Crucial financial data contained in the Income Statement and the Balance Sheet, as is the case with cash at bank, current assets, total assets, costs of sales, equity, can be extracted and used to calculate financial ratios.
2. How can financial ratios help financial management?
They provide management with a better long term visualisation of the outcome of its decisions as is the case with an increase in the unit price of goods sold or services rendered. The importance of financial ratios lies not in obtaining a single value for any given year, but in obtaining ratios for several years, so that a trend can be obtained, allowing a long term projection of the financial performance, which can then be analysed.
3. Why are long term trends of financial performance important?
The primary objective of the firm is survival in the long term, namely, long after the first year of operations. A long term view of the projected financial ratios, under varying scenarios can contribute to better understand the financial performance of the company, and if needed take corrective action so that the main goals of survival and profitability are achieved. The higher the return over 5% the higher the “equity premium” for making an investment that bears a risk of insolvency and therefore the risk that the invested capital is lost.