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What is a Financial Ratio?
What is a Ratio?
A ratio, in simple terms, expresses a relationship between two or more things. Ratio is an indicated quotient of two mathematical terms that shows a relationship and expresses a fact.
In the case of financial analysis, a ratio is used as a benchmark to estimate the financial position or to look at the financial position of the firm. It is to be noted that to form a ratio, at least two mathematical expressions are required. A single value, by its nature of individuality, cannot express a ration on its own.
What is a Financial Ratio?
The absolute accounting figures mentioned in financial statements do not express the exact financial performance of a firm. In order to assess the actual performance or strength, therefore, we need two or more expressions. When these expressions are combined, it may express a financial ratio.
An accounting figure cannot make sense in finance individually without being connected to another expression.
For example, to understand the net profit of a company, a look at the profit may not be sufficient. In order to attain a reasonable decision, the investment should also be considered.
The relationship between two or more accounting figures, which is expressed mathematically is known as a Financial Ratio. Financial ratios help to pinpoint at large financial data, and to show the qualitative aspect of a relationship between two financial figures. As the ratios are often used for qualitative judgment via mathematical expressions, they are considered to be backed by information on which we can rely more than anything else.
Important Note − A single entity cannot be considered as a ratio. To form a financial ratio, at least two mathematical expressions are required.
The use of ratios is widespread in finance and most of the financial decisions by financial managers are backed by estimation of these ratios. Financial ratios are built on particulars which are more relevant to emphasize rather than forming a decision depending on the guts. Financial ratios have evolved over the years as finance matured in the last few decades and now a sporadic number of financial ratios are available to finance managers to help them make a decision financially.
Nature of Financial Ratios
It is to be noted that in the case of ratios, quantitative expressions are used to make qualitative judgments.
For example, take the current ratio. It is given by current assets divided by current liabilities. So, the ultimate figure rests in the quantities of current assets and current liabilities figures. However, the ratio obtained by dividing current assets by current liabilities helps one to understand the company’s need to meet the current liabilities in the shorter term. So, it is the nature of ratios to show qualitative results by using quantitative terms in general. This is an inherent quality of all financial ratios.
Important Note − The nature of financial ratios is as such that quantitative expressions are used to get qualitative results.
It should be noted that financial ratios show a financial relationship between two terms. As in the case of the above example, the current ratio shows the relationship between current assets and current liabilities. These two are exact figures and are obtained from the actual market conditions. The current ratio is therefore a relationship between two facts.
All financial relationships are, however, not relevant or required to be expressed as financial ratios. As there are umpteen quantitative measures in finance, a lot of relationships may be found using them. All of these relationships are not usually required by managers, analysts, and investors. So, depending on the requirements and needs of the groups of individuals or professionals, different ratios have been already formed and used.
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