Financial Ratios and Their Interpretation

As an analyst looking over ratios for different companies as part of an investment evaluation, you may not know where to begin. There is a limitless number of ratios that can be created. They are in essence nothing more than a proportion of one number over another. When faced with an unfamiliar ratio, you will of course look at the number. What can you do next to help understand what a ratio means?

Correct. They will typically represent items from the financial statements like assets or revenues.

You are scratching your head a bit though. You remember that income is for a specific time period and assets are measured at a specific date. What would be the next piece of information you would like to find to clarify this ratio?

Not yet. This may be part of your analysis, but it doesn't affect how you would interpret this ratio.

Very good. This is useful information because, in a seasonal business like electronics retailing, asset numbers can fluctuate widely from month to month due to new product introductions and the holiday shopping season. A weighted average for the full 12 months would best reflect reality in that industry! A year-end number might be adequate for others.

Performance ratios like return on assets may be very useful for businesses with a large amount of fixed assets like the auto industry. But you are correct to question whether they would be as useful in technology where many firms have few assets or are too new to be earning profits. So don't be surprised to see different ratios used for comparing companies in different industries.

Incorrect. This is not true for all ratios. Performance ratios, for example, use assets as the denominator but others do not.

Not correct. You aren't ready for this step yet.

Incorrect. This isn't always possible, and if you found the ratio in a database, the source may be identified. You won't need to obtain it if you trust the database.

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Once you have the information as to what the numbers represent, you are probably asking yourself what the number means. You might ask yourself if a ratio with a higher number is better or worse than a company with a lower one, or whether an individual company's ratio should be getting higher or lower than past periods. The first ratio you often see is __return on assets__. The calculation is net income over assets. For this ratio, you will see that a company with a higher ratio than others is doing better at using its assets to make profits.

Find out what the numbers in the numerator and denominator of the ratio represent

Obtain the source document for the numbers in the numerator and denominator

Always divide the numerator by total assets

Find information for asset purchases planned for the upcoming year

Find out if the asset number is from end of year, beginning of year, or an average of all months

Obtain the income statement forecast for the next year

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