Financial Ratios: The Intersection of Economics and Finance
Students of finance, business managers, and private investors rely on financial ratios as indicators of economic and financial success. Financial ratios are not completely under management's control—there is the influence of broader economic forces on each of the critical ratios. Ratios can, unfortunately, also be a crutch and barrier to good decision making. Surprisingly, the role of financial ratios in decision making for the investment analyst and the business leader is far more interesting and crucial to success than the sterile reporting of a number often conveys.
Often, analysts of financial data tend to immediately make judgments based on a financial ratio: The P/E (price/earnings) ratio is too high; interest expense is in line with income; the return on assets is too low. However, it is important to consider three boxes to check off before getting too involved in the trees and losing sight of the forest.
Targets, Indicators, or Instruments
What do we mean by the three boxes labeled targets, indicators, and instruments? Many financial ratios act as targets for decision makers much in the way that the Federal Reserve targets price stability. As a target, the financial ratio, earnings per share, is a good example, and is the goal of the leaders of many companies. Second, a financial ratio can also be an indicator of financial performance such as the return on equity. Finally, a financial ...