External, rather than internal, stakeholders of a company are most interested in the analysis of key financial ratios. While internal stakeholders like corporate managers may use financial statement ratios to flag problems requiring attention, they have access to a far greater range of other financial information than external stakeholders to make their decisions.
External stakeholders simply have the financial statements covering past periods as their only source of information to give them insights into the financial position and performance of the company. So a ratio analysis of the income statement and balance sheet to calculate the key financial ratios is vitally important to them.
Typical External Stakeholders Include:
- Existing or potential investors in the company and their share analyst.
- Existing or potential loan providers (bank or finance company) in regard to a company’s creditworthiness.
- Existing or potential suppliers providing credit arrangement to the company (creditors).
Key Financial Ratio Areas
These external stakeholders are most interested in using the financial ratio analysis to answer questions about five key areas of concern:
1. The extent to which the company is relying on external debt to fund its operations and plans.
An analysis of the debt management ratios helps stakeholders assess the liquidation risk that excessive debt funding can have on the company’s viability as well as the profit impact of interest rate changes.
2. The ability of the management to efficiently and effectively manage the assets under their control.
An analysis of the asset management ratios helps internal and external stakeholders identify poor management performance in regards to the administration of assets like inventory, fixed assets and debtors.
3. The financial sustainability of a company and its ability to generate sufficient profits to meet the expected returns of investors.
An analysis of the profitability ratios helps internal and external stakeholders monitor the selling price policy and provides a comparable return on investment benchmarks against assets employed and equity invested.
4. The attractiveness of the company as an investment option in a competitive market for capital.
An analysis of the market value ratios helps both internal and external stakeholders identify the current market perception of the company in regard to future profit potential.
To obtain a complete view of the financial position and performance of a business, a stakeholder would need to combine the financial ratio analysis with non-financial metrics (brand value, management reputation, PR or Press status) as well as comparing these ratios with previous years and with industry or competitor benchmarks.
Typical Financial Ratios Analyzed in Each Area of Concern Include:
Liquidity Ratios: Current ratio and acid test ratio.
Debt Management Ratios: Debt-to- equity ratio (leverage) and times interest earned.
Asset Management Ratios: Inventory turnover and average collection period.
Profitability Ratios: Gross profit percentage of sales, net profit percentage of sales, return on assets (ROA), return on equity (ROE).
Market Value Ratios: Price-earnings ratio (P/E) and dividend yield.
What Each Ratio Means:
Current Ratio: Funders generally look for $2 of assets that can be easily converted to cash for every $1 of current liability to ensure the company can pay its bills as they fall due.
Acid-Test Ratio: Having $1 in cash for every $1 in current liability is a further indication that the company can easily pay its bills when they fall due.
Debt-To-Equity Ratio (Leverage): Debt funding of 40 percent of total assets to equity funding of 60 percent is generally considered a manageable level of debt for most companies. This does vary significantly from industry to industry. The greater the percentage of debt, the greater the risk the company is from being liquidated by external parties.
Times Interest Earned: A high number here gives comfort to funders that the company is easily able to pay the interest bill on their loan funds and can cope with interest rate increases should they be required in the future. Four to six times is generally considered safe.
Inventory Turnover: A lower number than the industry average means you might be holding too much inventory—a higher than industry average may mean you are sometimes running out of inventory and not maximizing sales.
Average Collection Period: This is an important metric for cash flow management and is usually monitored against previous periods. If the ratio increases, it means that debtors are paying their debts slower which can impact your ability to meet your obligations.
Gross Profit Percentage of Sales: Lower than industry average could mean the company is discounting its prices, there is a misappropriation, or retail prices are not being adjusted for increases in cost prices.
Net Profit Percentage of Sales: This ratio identified by the safety margin the company has against negative impacts on its selling prices or costs. This is usually monitored against previous periods to flag any signs of deterioration in the company's sustainability.
Return on Assets (ROA): This ratio looks at the amount of asset investment being used to produce the profit. The ratio identifies when the management is over-capitalizing the business and possibly tying up funds that could be used better elsewhere.
Return on equity (ROE): This widely used ratio indicates the earning power of a shareholder investment and is frequently used in comparing two or more companies in an industry. The ratio focuses on the returns available to ordinary shareholders.
Price-Earnings Ratio (P/E): Identifies the market sentiment concerning the future profit potential of the company. Greater than 16 P/E means the market believes that profits will increase in the future and less than 16 PE that the market expects profits to fall from their current position.
Dividend Yield: Allows investors to compare the cash flow returns from investing in the company against putting the money into fixed interest investments.
Read Peter Baskerville’s answer to, “What Are the Key Financial Ratios to Know When Going through Financial Statements of Any Company?” on Quora.