Background
Financial ratios are valuable tools typically derived from a company’s financial statements. They are instrumental in assessing various aspects of a company’s performance, financial health, and potential for future growth and profitability. A financial ratio involves the computation between different quantities from the company’s financial statements.
Historical Context
The use of financial ratios dates back to the early 20th century and became increasingly significant as the financial markets evolved. Over the years, analysts and investors have developed and refined numerous financial ratios to aid in investment decisions and comparative financial analysis.
Definitions and Concepts
Financial ratios are derived from a company’s accounts and are applied effectively to evaluate a firm’s performance. Some of the key ratios include:
- Price-Earnings (P/E) Ratio: The ratio of the market price per share to earnings per share.
- Price-Dividend (P/D) Ratio: The ratio of the market price per share to the latest dividend paid per share.
- Current Ratio: Current assets divided by current liabilities, indicating liquidity.
- Debt to Equity Ratio: Total liabilities divided by shareholders’ equity, signaling financial leverage.
- Return on Equity (ROE): Net income divided by shareholders’ equity, showcasing profitability.
Major Analytical Frameworks
Classical Economics
Classical economics, with its foundation in the works of Adam Smith and David Ricardo, emphasized the production and accumulation of capital rather than a structured approach to accounting ratios which became apparent more explicitly in later economic schools.
Neoclassical Economics
Neoclassical economics focuses on the equilibrium and efficiency of markets, making financial ratios useful in predictions of market efficiency and company performance. Ratios here can indicate how well a company is performing in a theoretically efficient market.
Keynesian Economic
Keynesian economics is more concerned with macroeconomic factors, but on a microeconomic level, sound financial ratios in companies would point towards stability, contributing to overall economic stability.
Marxian Economics
Marxian economists might use financial ratios to analyze the distribution of wealth within firms and to critique the disparities between capital and labor income.
Institutional Economics
Institutional economics considers the role of institutions, regulatory environments, and contexts in shaping financial performance, where financial ratios help in understanding systemic risks and firm-level performances relative to these broader structures.
Behavioral Economics
Behavioral economics showcases that investor sentiment and market behavior can be influenced significantly by various financial ratios.. The P/E ratio, for example, is notably impacted by investor optimism or skepticism.
Post-Keynesian Economics
Post-Keynesian economists use financial ratios to understand firm behavior under uncertainty, investment fluctuations, and the potential risks of financial instability.
Austrian Economics
Austrian economics, focusing on the importance of individual actions and the subjective nature of value, may critically assess how financial ratios reflect individual entrepreneurial action and decentralized market workings.
Development Economics
In development economics, financial ratios assist in assessing the viability, efficiency, and profitability of firms in developing economies, enlightening sectors requiring further investment or policy intervention.
Monetarism
Monetarism would typically focus on the impacts of monetary policy on financial markets, where valuations indicated by financial ratios, such as P/E, could reflect inflation expectations and the impact of monetary supply variations.
Comparative Analysis
Comparing financial ratios across industries and over time provides an analytical framework to compare firms of different sizes and types, contextualizing company performance against its peers and the industry standard.
Case Studies
Study 1: Ratio Analysis in the Tech Industry
Study 2: Financial Ratios as Predictors of Bank Failures
Study 3: Comparative Analysis of Financial Ratios in Startups vs. Established Firms
Suggested Books for Further Studies
- “Financial Ratios: What They Mean” by Jarrod Waugh
- “Analysis for Financial Management” by Robert Higgins
- “Financial Reporting and Analysis” by Charles H. Gibson
Related Terms with Definitions
- Liquidity Ratios: Ratios that measure a company’s ability to meet short-term obligations.
- Leverage Ratios: Ratios that signify the extent of a company’s reliance on debt.
- Profitability Ratios: Ratios reflecting the ability of a company to generate profit relative to sales, assets, or shareholders’ equity.
- Market Value Ratios: Ratios that provide insights into the market perception of a company’s worth.
By understanding these categories and their specific applications, stakeholders can gain sophisticated insights into a company’s comparative merits and future performance potential.
