Question

Think of interested parties who are using financial ratio analysis to help them in their decision-making. How do they use them?

Answer 1

Out of all the financial ratios (more than 20), there are only few handful of financial ratios which are actually useful and utilized as per their need by the interested parties.

Moreover, the financial ratios vary based on the sectors / Industries. So, the concept of "One size fits all" does not apply here and the analyst should be vigilant about the industry one is analysing.

So, the following ratios are used widely and preferred:

1. ROE - Out of all the shareholders equity available, how much return the company is able to churn out. And, this actually interests investors.

2. ROCE / ROIC: Return on capital employed or Return on Invested Capital can tell the investors about the performance of the firm based on the capital invested in a particular period. So, regardless of the years of presence of a firm in the market, it can tell the current performance.

3. Interest coverage ratio - This shows that how many times a company can cover its interest payment from its earning. Usually it should normally be 2 or 3.

4. Debt/ Equity ratio - This shows the position of debt of a firm. This parameter is industry specific as for banking sectors, debt is an asset but, for others, it is a liability. Generally, The lesser the debt, the better a firm stands out to take decision about its organization.

Hope this clears the understanding.