Why Financial Ratios are important and how to use them

Financial ratios cover the basics of financial analysis: activity, liquidity, solvency, and profitability. But when it comes to understanding a business, you should view these ratios as a starting point, not an ending point. Financial ratios are the tools you can use to understand the characteristics of a company. It doesn’t take you long to figure out, however, that there are hundreds of different ratios, as well as variations of the basic ratios given the industry you’re looking at, the company you’re looking at, or even the slant of the analyst.

This plethora of analytical possibilities makes things confusing for the beginning investor. After a while, you get used to the fact that every business textbook has a different definition of free cash flow, or that retailers don’t have receivables (retail is a cash business), so their working capital ratios look a little different. Such variation al- lows for the fact that investing isn’t static. Companies change and your ability to use ratios smartly, in ways that isolate the relationships you’re trying to identify, will improve as you learn to tweak them this way and that, or create new ones.

Unfortunately, this lack of standardization means that even the categories of ratios aren’t exact, but they give you a feel for what each ratio is trying to measure. Ratios fall into four basic categories

Next blog posting – Current Ratio