Financial Ratios are the basic tools used by all lenders to examine the financial health of companies. Lenders use them on their existing clients, prospective clients, and on other companies as part of the credit assessment process.
Financial Ratios are extensively used across the globe; they are simple and it’s quite straightforward to determine their values.
The Financial Ratios reflect upon the different areas of the financial well-being of a company viz. liquidity, indebtedness, debt servicing capacity, solvency, and efficiency. Financial Ratios are multipliers and not absolute numbers, which makes an easier comparison across companies.
Financial Ratios in isolation do not reflect much; they are effective once comparing them across different companies, compared with the previous year’s ratios, and compared against the benchmark financial ratios.
A trend of financial ratios throws light on the changing position of the various financial parameters of a company. Trends in Financial Ratios of a Company are analysed for the last few years to shed light on the following:
1. How the various indicators of the financial health of a company have moved?
2. Reasons for the deterioration in a financial parameter
3. Factors that strengthened a financial parameter
4. Changes in the profitability
5. Efficiency of working capital management
6. How the company has been financing its growth/ business
7. Change in the composition of the sources of capital i.e., Debt & Equity
8. How the Debt servicing capacity has changed
9. Efficiency in asset usage
10. Movement in return to shareholders
The Financial Ratios of a Company are not strictly comparable to the Financial Ratios of another company operating in a different Industry. The operating dynamics of the industry result in certain skewness in some of the financial ratios making a comparison of companies across industries, not an ideal position.
The trend in Financial Ratios is compared with competition in the same industry to get a sense of the profitability, liquidity, working capital efficiency, debt servicing capacity, indebtedness, etc.
The Financial Ratios trend of companies is often compared with the trend of the financial ratio set as industry benchmarks to reflect upon the following:
1. Assess how the company is doing on various financial ratios like Profitability, Liquidity, Leverage, Solvency, and Efficiency vis a vis the industry benchmark
2. Determine the steps to be taken to correct the company’s position on financial ratios it is out of sync with the benchmark
3. Determine the Financial ratios for which the company should maintain its position.
Analysis of the trend of financial ratios enables in reading the early signs of strain in the financials of a Company; measures could then be taken to have an early resolution of the situation which otherwise could precipitate into a financial crisis.