Various Uses of Financial Ratios

Analysts rely on financial ratios in four main areas of investment:

• evaluating stocks;
• evaluating a stock’s exposure to the systematic risk;
• estimating credit quality of fixed-income securities; and,
• forecasting the potential of a company to default on its financial obligations or file for bankruptcy.

Evaluating Stocks

Most stock valuation models are based on calculating or estimating discounted present values of cash flows. There are other quite popular models as well; such are relative valuation models, one example of which is the price-to-earnings (P/E) ratio.

Notably, regardless whether an analyst is examining discounted present values of cash flows or relative valuation ratios, both approaches require estimates of a company's growth rates of earnings, cash flows and dividends, which is where financial ratios come particularly handy.

For example, when estimating the required rate of return, an analyst will have to look into a company’s business, financial and liquidity risks. Furthermore, the business risk is usually measured with respect to variability, the financial risk is typically expressed through debt proportion and earnings coverage ratios, while the liquidity risks can be measured by comparing external factors, such as trading turnovers or bid/ask spreads.

Estimating Systematic Risk

The capital asset pricing model (CAPM) claims that the only relevant risk variable for any asset is its systematic risk, which is expressed through the asset’s beta coefficient relative to the market portfolio that includes all risky assets.

If a market is considered efficient, there should exist an observable relationship between company-related internal risks (business and financial risks) and market-related risk factors (beta). These variables are usually expressed as 5-year averages, and include dividend payout ratios, debt-to-equity ratios, cash flow-to-debt ratios, interest coverage ratios, liquidity ratios, etc.

Estimating Credit Ratings/Potential for Bankruptcy

Analysts, investors and creditors alike have always relied on financial ratios to tell them what the possibility is, if one existed at all, of a company’s default on its financial obligations and/or bankruptcy. Based on such analyses, companies’ debt issues were assigned credit ratings.

The pattern to look for is the decline in liquidity and debt ratios over at least five prior years. Some of the more frequently used ratios are debt-to-equity and debt-to-cash flow ratios, profit margin ratios, retained earnings, liquidity ratios, etc.

Financial Ratios Limitations

Of course, there is no such thing as a perfect evaluation tool, particularly not in finance. One of the first questions analysts must answer pertains to reliability of accounting measures used by a company to derive financial ratios input values. This comparability of acceptable accounting methods becomes even more important when analyzing non-U.S. companies.

Furthermore, analysts should apply more comprehensive and cross-industry analysis of non-homogeneous companies. These days, many companies have divisions and subsidiaries that operate outside the parent company’s core business. Such corporate structure makes it particularly difficult to analyze comparable industry ratios.

In addition, when evaluating a company, it is important to build a complete picture and not rely on only one or two sets of ratios. For example, it is quite possible for a firm to be profitable, while having short-term liquidity issues.

Finally, once relevant financial ratios have been calculated, analysts should make comparisons with the average values reported for an industry. No man is an island, and the same goes for any company. Financial ratios should not be observed in a vacuum, but compared to industry averages. Being too much outside an industry-appropriate range could represent a problem.

Source: Investment Analysis and Portfolio Management, Eighth Edition, by Frank K. Reilly and Keith C. Brown, 2005.

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