2.2 Financial Ratios
Financial statements provide key information about a company’s operation. More in depth data about a company’s performance can be revealed by calculating financial ratios using the information from the statements. A financial ratio is a measure of the relative magnitude of two selected numerical values. For instance, the gross profit ratio expresses the numerical relationship between gross profit and sales. If a company has a gross profit ratio of 0.25, this means that for every $1 of sales, the company earns $0.25 on average to cover expenses other than cost of goods sold. Another way of stating this is to say that the gross profit ratio is 25%.
Financial ratios are an effective tool for measuring the financial performance of a company. They provide a common basis for evaluation—for instance, the amount of gross profit generated by each dollar of sales for different companies. Numbers that appear on financial statements need to be evaluated in context. It is their relationship to other numbers and the relative changes of these numbers that provide insight into a company’s performance. For this reason, ratios are often compared to industry averages to get a better picture of how the company is doing, or to past years’ ratios to determine trends in a company’s performance.
There are five major types of financial ratios:
- profitability ratios that measure various levels of return on sales, total assets employed, and shareholders’ investment;
- debt management ratios that measure the financial structure of a company, its amount of relative debt, and its ability to cover interest expense;
- asset management ratios that measure the company’s inventory and asset profitability and company’s ability to collect on accounts receivable;
- liquidity ratios that measure the ability of a company to satisfy demands for cash as they arise in the near-term (such as payment of current liabilities); and
- market value ratios that measure financial returns to shareholders, and perceptions of the stock market about the company’s value.
It is important to note that financial ratios are only one of the tools used in company’s performance analysis. They show only one side of the story. For example, a company may have sold hundreds of refrigerators last year and all of the key financial indicators may suggest growth. However, trade publications and consumer reports may indicate the arrival of new technologically advanced refrigerators in the next few years. So, if the company does not have the capacity or necessary equipment to produce these new appliances, the present positive financial indicators may not accurately reflect the likely future of the company.
In this section, we will calculate financial ratios to get some insight into Canadian Tire’s performance. The ratios will be obtained based on information from Canadian Tire’s income statement and balance sheet for the years 2015 and 2016. While the ratios themselves often provide useful informa