# Importance of Financial Ratios

**Topics:**Financial ratios, Financial ratio, Balance sheet

**Pages:**6 (2244 words)

**Published:**June 9, 2011

Introduction

Financial ratios are derived ratio numbers from the financial statements of a company. Depending on the task, financial ratios can serve to various purposes in accounting, legal, M&A uses, etc. For investors, financial ratios are very powerful in two ways: indentifying the company’s unique competitiveness and evaluating its stock price level. The first part helps investor find a truly valuable company and the second part helps investor buy the stock at a bargain price. Comparison of Financial Ratios

With few exceptions, a great company must have strong competitiveness in its products, operation or management. Financial ratios are a valuable and easy way to interpret the numbers found in statement (Financial Ratios, 2010). Stable and fast growing companies in the past years must have strong financial results in their books and financial ratios can reveal the firm’s strength over its competitors. Some simple ratios will clearly tell us the company’s cash richness and low debt status. The comparison of these ratios over its industrial rivals helps us know the company’s relative position in the industry (Table I). Similar comparison across different industries can tell if this is an over-competitive, low margin industry or it is a fast growing, highly profitable industry. For example, the average growth rate and net income margin of the computer industry is more sensitive to the economy cycle than other consumer industries like the food and drink industry, a clear indictor that the high-tech sector is in furious competition environment (Table II). On the other hand, the pharmacy industry is more defensive to the economy environment, showing better financial ratios in the recession time, but its profitability is not very impressive due to the high R&D expenses and fast equipments depreciation. (We can easily find different industry financial statistics from internet, e.g.,). Other important financial ratios also tell the story of a firm from different angles, such as the gross margin, EPS growth rate, return on equity, etc.,. For example, it takes less than a minute to know that Apple Inc. is a brilliant company, when reading a revenue growth (YoY) 66.7%, EPS growth (Qtrly YoY) 67.5% and Return on Equity (ttm) 35.28% (Table I) (Apple Inc. , 2010). Table I Comparison Between Companies (Apple Inc. , 2010)

2009AppleMicrosoftDellHewlett-Packard

P/E20.9511.6217.3111.65

P/B6.14.94.312.4

Profit margin21.48%31.32%2.68%6.95%

Operating margin28.19%41.55%4.86%10.25%

ROA18.73%19.73%5.30%6.75%

ROE35.28%46.73%28.87%21.64%

Debt/Equity022.7285.3155.14

Current ratio2.01%2.31.41.1

Book value per share52.17%5.483.1717.99

PEG ratio (5 yr expected)0.841.111.330.87

Price($)3172713.6943.03

Cost of goods sold ($m)39,541 12,395 43,641 87,524

Average inventory ($m)753 729 959 7,004

Inventory turnover52.51117.01445.50712.497

Table II. Comparison Between Industries ( Industry Center, 2010) IndustryAutoPhmaBiotechnologyCommunication EquipmentsSoft Drink P/E8.713.878.622.518.7

P/B1.411.26.82.612.2

Net Profit Margin (mrq)4.80%19.40%12.70%4.80%11.70%

ROE15.40%16.50%9.80%6.60%22.70%

Debt / Equity118.599.45236.644.7

With a more systematic treatment, we can divide the financial ratios into four types, the liquidity ratios, profitability ratios, activity ratios and leverage ratios, each of which illustrates the company strength or weakness in one major area. We will discuss the most representative ratios in these categories below. Liquidity Ratio

The liquidity ratios are a class of ratios that represent the percentage of cash-like assets vs. other assets or liability. On one hand, these ratios illustrate the company’s ability to pay off its short-term obligation (Liquidity Ratios, 2010), but more importantly, we are able to immediately conclude on the company’s long term...

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