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5 Essentials While Managing Financial Ratios

Home5 Essentials While Managing Financial Ratios

For doing financial analysis of the company, it is important to learn about the financial ratios and the Company’s corporate governance. So, to manage the financial ratios, we have come up with 5 essential points. Know about them to get the good hold of the business’ finance.

But before jumping on to the topic, let us learn about ‘ratio analysis’ in brief. So, what actually is ratio analysis? This is a process to understand the performance and financial position of a business by mathematically interpreting financial statements. It analysis the performance at two levels:

►   Trend analysis: To compare the performance of a company over a period of time.

►   Peer group analysis: To compare the performance of a company with other company’s within the same industry/ sector.

For any organization, it is necessary to access the management efficiency as per business progress & opportunities and in this Financial Ratios are used as a tool for analyzing.

Now the question is how to manage the financial ratios without fail. Do not worry, as you can easily do that by following 5 essential aspects, which are:

1. Do not get mislead with single ratio strength: Different metrics are used to calculate the financial statements & business efficiency, but always remember that you do not get swayed away with the results of single ratio, as in isolation, these do not lead to a right path but with totality they appropriately can.

Therefore, during financial investigation, consider ratio analysis under 4 main categories.

1. Profitability Ratios

2. Valuation Ratios

3. Efficiency Ratios

4. Liquidity & Credit Ratios

2. Compare oranges with oranges: If you are doing the ratio analysis, then remember to compare the performance either with the historic performance or with another company’s performance from same sector or industry. This would make it easy for you to calculate the profitability margins and efficiency ratios. It is important to calculate the evaluating ratios in totality and benchmarking the ratios to industry standard and not comparing ROE across different industries.

3. Avoid benchmarking beyond a point:

Although making comparisons is good in analyzing the current position and judge company’s performance, however, you have to keep this in consideration that there is certain difference in the standard ratio of all business and industries. This is why benchmarking should be done with caution and should be periodically adjusted as well according to the future outlook.

4. Basis for calculating ratios:

The accounting policies of different companies might differ from one another therefore, before calculating the ratios, the basis of the financial statements should be presented uniformly. If it is not uniform then, make certain necessary changes in the presentation and classification.

5. Try to spot window dressing:

Beware of the manipulations in the statements, as it is easy to improve the company’s performance in the financial statements. This is known as window dressing, which is done for public shareholders, who have little information about daily activities of the company. It is although difficult to spot such accounting issues but getting the insight over it gets easy reviewing the financial statements and longer trends adopted.

So, these are the 5 essential aspects, you need to consider while analyzing the financial ratios and clear out the broader concept properly.

About the Author

Rajat Sharma pictureRajat Sharma is a well known stock market analyst and commentator. He has covered Indian markets for over a decade and is regarded for consistently identifying early stage investment opportunities. Attorney by qualification, Rajat has done extensive work for improving corporate governance and disclosure standards.