Analysts, company management and lenders use financial ratios to assess a firm's financial health and operational efficiency. Financial-ratio analysis performed throughout the year provides performance information during busy or slow seasons. Financial ratios, averaged by industry, serve as a benchmark for comparison against individual companies and help users make informed investing and credit decisions.
Understanding Financial Ratios
Financial ratios provide information on a company's financial strength, efficiency, profitability and other business measurement metrics. Comparing an individual firm's ratios against average ratios for its industry or a group of its competitors provides additional, valuable insight. Commercial-bank lenders rely on industry-average ratios to evaluate a firm's viability and credit risk. Average financial ratios by industry come from publications such as "Robert Morris Associates Annual Statement Studies" (RMA), which is considered the industry standard by commercial lenders. Local libraries carry this publication, along with others such as Dunn & Bradstreet publications and the Almanac of Business and Industrial Financial Ratios, using data taken from the IRS and U.S. Treasury statistics.
Assessing Industry Averages
Ratios illuminate a company's financial condition when used together. Many industries have financial-ratio results that define their way of doing business. For example, utility companies use more leverage than most companies, causing their debt-equity ratio to run higher than average. Analysts and investors might consider a highly leveraged company to be riskier, although utility firms, because of the stability of their business, do not necessarily represent higher risk even with their higher debt-equity ratio. It is the norm for their industry.
Various Forms of Interpretation
Ratio analysis requires a starting reference point. Ratios take on meaning in the context of comparison to the firm's historical results, projections, ratios of similar companies along with average ratios for the firm's industry. Additionally, most individual financial ratios do not tell much of the story. Each one should serve as an indicator, with several ratios together providing a picture of the company's overall situation. When comparing to industry-average ratios, the analysis must also consider company differences that may affect ratio results, including a firm's age, management team, locations, operations and other characteristics.
Financial-Ratio Limitations
Financial ratios expedite the financial analysis of large amounts of company data. They provide a consistent basis for measurement used across firms and within industries. All financial ratios run the risk of manipulation through questionable accounting practices. Additionally, a firm choosing different, although legitimate, accounting methods may experience non-comparable ratio values. Certain account balances used for ratio calculation could change during the year because of seasonality. This causes distortion in the ratio values, and average account balances provide more meaningful ratio results.
