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Wednesday, 12 June 2013

Important Financial Ratios For Analyzing Businesses

Financial ratios are tools used to analyze financial conditions and performance of any businesses. In themselves, the raw numbers on your balance sheet, income statement and cash flow statement have limited value.  Performing a simple comparisons between specific numbers pulled from your balance sheet, income statement and cash flow statement provide meaningful ratios for evaluating your company's financial performance and making critical management decisions, 

Financial ratios give you a sense of how a company is faring, or how a company compares in terms of valuation to another company. They are metrics that can be used to help you compare companies across sectors, or companies with competitors, or just get a sense of how companies are performing.

Financial ratios analysis is one of the most important element in the fundamental analysis process. It means different things to different people. Lenders and creditors analyse the liquidity ratios of a company to evaluate credit risk. Business owners and managers use the information to evaluate the company performance, comparing performance against that of the competitors and industry and make critical decisions. Investors make use of the results of the analysis to arrive at their investment decision.

Financial ratios which are relevant to the investing process are categorized into six main areas as follows:

  1. Liquidity Ratios
  2. Profitability Ratios
  3. Debt Ratios
  4. Operating Performance ratios
  5. Cash Flow Ratios
  6. Investment Valuation Ratios
I am using the financial statements of Cisco Systems, Inc. (CSCO) to compute and explain the financial ratios.

1) Liquidity Ratios

The Liquidity Ratios measure a company's ability to pay off its short-term debt obligations. The four most commonly used Liquidity Ratios are:

a) Current Ratio

b) Quick Ratio
c) Cash Ratio
d) Cash Conversion Cycle

2) Profitability Ratios

The Profitability Ratios measure how well a company utilized its resources in generating profit and shareholder value. The four most commonly used Profitability Ratios are:

a) Profit Margin Analysis
b) Return on Assets (ROA)
c) Return on Equity (ROE)
d) Return on Capital Employed (ROCE)

3) Debt Ratios

Also known as Leverage Ratios or Solvency Ratios. Debt Ratios measure the stability of a company and its ability to repay debt. The five most commonly used Debt Ratios are:

a) Debt Ratio
b) Debt-Equity Ratio
c) capitalization Ratio
d) Interest Coverage Ratio
e) Cash Flow to Debt Ratio

4) Operating Performance Ratios

The Operating Performance Ratios measure how efficiently and effectively a company is using its resources to generate sales and increase shareholder value. The two most commonly used Operating Performance Ratios are:

a) Fixed-Asset Turnover
b) Sales / Revenue per employee

5) Cash Flow Ratios

The Cash Flow Ratios look at how much cash is being generated and the safety net that it provides to a company. The three most commonly used Cash Flow Ratios are:

a) Operating Cash Flow / Sales Ratio
b) Free Cash Flow / Operating Cash Flow Ratio
c) Dividend Payout Ratio

6) Investment Valuation Ratios

The Investment Valuation Ratios compare a company current share price against its performance.or profitability. The seven Investment Valuation Ratios that will be discussed are:

a) Price / Book Ratio
b) Price / Cash Flow Ratio
c) Price / Earnings Ratio
d) Price / Earnings to Growth Ratio
e) Price / Sales ratio
f) Dividend Yield
g) Enterprise Value Multiple 

When using the financial ratios, please keep in mind that no one ratio or formula should be used in isolation.

Ratios by themselves don’t mean much. Looking at a company's ratios at one point in time is meaningless. Some means of comparison is needed, whether it’s comparison against the historical ratios of the same company, or comparison against the ratios of another company or a set of companies.

Looking at a particular ratio alone is also dangerous. Management can manipulate certain things on the income statement or balance sheet, so they don’t reflect the true state of being. There are ways to defer revenues or expenses into future periods. Management can manipulate these ratios so they appear better than they are, or even worse than they are. Looking at a set or group of ratios instead will provide better understanding of the actual financial state of the company.

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