Classification of Ratios
One of the ways in which financial statements can be put to work is through ratio analysis. Ratios are simply one number divided by another; as such they may or may not be meaningful. In finance, ratios are usually two financial statement items that may be related to one another and may provide the prudent user a good deal of information.
Of the myriad of ratios that could be generated, some will be more meaningful than others. Generally ratios are divided into four areas of classification that provide different kinds of information: liquidity, turnover, profitability, and debt.
- Liquidity ratios indicate a firm's ability to meet its maturing short-term obligations.
- Turnover indicates how effectively a firm manages resources at its disposal to generate sales.
- Profitability indicates the efficiency with which a firm manages resources.
- Debt indicates the extent to which a firm is financed by debt.
Remember, ratios are just one number divided by another and as such really don't mean much. The trick is in the way ratios are analyzed and used by the decision maker. A good strategy is to compare ratios to some sort of benchmark, such as industry averages, or to what a company has done in the past, or both.
Once ratios are calculated, an analyst needs some benchmarks to find out where the company stands at that particular point. Useful benchmarks are industry comparisons and company trends.
It may be useful to compare a company to certain industry averages to get a feel for how the company is performing. In this case it is necessary to obtain industry performance measures. There are a number of sources for industry figures.
- Commercial Sources – A number of companies publish information on industry comparisons. Among these sources are private credit reporting agencies such as Dun & Bradstreet and RMA - The Risk Management Association. Rating agencies such as Moody's and Standard & Poor's also provide industry information.
- Government Sources – There are a number of government sources of helpful industry information, such as the U.S. Industrial Outlook and Quarterly Financial Reports.
- Trade Associations – Many industries have trade associations or industry groups that regularly publish information for and about members.