For business leaders and decision makers, financial ratios are indicators of financial performance as well as part of a broader financial and economic framework. Utilizing financial ratios within that framework provides business leaders with a context for making well-informed decisions about their firm and the economy in general.
Financial ratios serve several purposes. They can be targets that can trigger an action, such as an investment decision, or act as measures of financial performance for a firm, industry, or country.
It is important to note that a financial ratio describes what happened but not why it happened. When looking at companies, an analyst compares financial ratios of one company to its competitors to understand the underlying causes of divergence between firms and the industry. The same can be true when a decision maker evaluates a country's financial position.
When using a financial ratio, an analyst should decipher the numerator and the denominator to assess what the ratio is attempting to measure and how to interpret the results. Financial ratios enable a decision maker to determine past performance, assess current performance, and gain insights regarding future success.
Generally speaking, calculating ratios can be the easy part of the task. The real challenge is extracting the underlying meaning of the ratios. An analyst must establish a methodology to assess the direction, stability, and outlook for the trend in the data that makes ...