What is the purpose of a financial ratio ?

Financial ratios are essential in any business acquisition, commercial partnership or capital contribution project. Indeed, financial ratios allow to evaluate the financial health of a company. They are therefore decisive for potential buyers, partners and investors of a company.

Financial ratio: definition

A ratio is a financial analysis tool. It allows to determine key indicators from the accounting records of the’company. A financial ratio can be expressed in the form of a percentage or a coefficient depending on the desired interpretation of the result.

The analysis of a company’s financial ratios provides an overview of its financial statements and its ability to create value.

Ratios provide various financial information on a company (profitability, solvency, liquidity, average stock, cash flow, financial balance…). Thus, they can be used to to improve the readability of financial data of a company and to manage its overall evaluation.

In concrete terms, a company’s financial ratio is calculated by taking a ratio of the total amount of the company’s assets and liabilities ratio between specific accounting values. It can be based on past or present data depending on the objective sought. The retrospective approach allows, among other things, to draw up a functional and operational balance sheet of the establishment.

More recent information, on the other hand, is excellent decision support tools.

Business leaders often prefer ratios that use data reflecting the present. In this way, they can deploy the best strategy to ensure the development of the company. Future partners or shareholders, on the other hand, prefer past information to evaluate the feasibility and potential of the business’a project.

How to calculate the ratio’financial autonomy ?

In general, the calculation of a financial ratio is based on figures from the company’s balance sheet. This principle applies in particular to solvency ratios and structure ratios. This is also true for the financial autonomy ratio.

This indicator represents the level of net debt of the company’an establishment vis-à-vis its creditors.

This ratio is obtained from the division between the value of the shareholders’ equity of a company and the total amount of its balance sheet. This method makes it possible to evaluate the importance of equity capital in relation to the company’s resources. Note that in a healthy company, this ratio is greater than 0.2 (or 20%).

Below this threshold, the company can be considered as not financially autonomous. However, the indicator should be distinguished from the financial independence ratio. The latter allows to estimate the balance of the financial structure of the company.

It is obtained by dividing the amount of the company’s equity by the amount of its permanent capital. In a healthy company, this ratio is greater than 0.5 (i.e. 50%).

How to interpret financial ratios ?

The interpretation of a financial ratio depends fundamentally on the subject and the purpose of the analysis. As an example, the liquidity ratio allows to evaluate the capacity of a company to pay its short-term debts. Indeed, this ratio allowsTo appreciate the total amount of cash available to pay the possible debts of the company.

In other words, the liquidity ratio represents the turnover of current assets compared to total liabilities circulants. The operator is solvent, if the coefficient in question exceeds 1. This type of threshold represents the basis for interpreting a company’s financial ratio. Like financial indicators, the reference value can be met as a percentage or coefficient.

Financial data readers most often focus on revenues and profits. Their first reflex will be to consult the ratios based on sales and margins. This information must therefore be put forward and treated with attention.