Evaluating Financial Ratios

Any decision maker or analyst should first understand the unique characteristics and environment of the respective industry in which it functions. For example manufacturing or wholesalers tend to have lower current ratio than retailers. The businesses which do not carry any inventory commonly have lower current ratio than manufacturing or merchandising firms. Smaller firms with unstable earnings have higher current ratios than large firms with greater reliable sources of cash receipts and revenue are capable to operate with lower current ratios.
Higher current ratio indicates the greater paying ability, but an extremely higher current ratio like 5 to 1, 4 to 1 may result in the “tide up” of firm’s resources in current assets. To sustain a greater liquid position the firm may be passing up opportunities for growth.

Standards of Comparison

If Bobby Company has figure of current ratio as 1.82 to 1, for evaluating such figure what standards for comparison should generally be used. Decision makers commonly use two criteria in evaluation of ratios. First is yearly trend in ratio, to know about the trend analyst can easily determine the firms performance is deteriorating or improving over a period of years. Second criterion, when analyst or decision maker compares firms financial ratios with the firms industry and overall industry average for respective ratios. In the light of these decision criterions, decision makers evaluate a particular ratio with current business environment.

Financial ratios are very useful tools to evaluate the performance of a firm, the person who understand the unique features of the firm and the dimensions of the industry can only interpret the ratios properly.