Tag: ratios

So how to go about organizing financial ratios in proforma sheets?

The best way to go about doing this is to divide the ratios into five broad categories and use these categories to classify the core category ratios within each of these classifications. The categories could be:

• Liquidity Ratios – tells you if the company can pay off its debt and payments falling due within a year
• Activity Ratios – important for manufacturing companies in order to analyze if the inventories, accounts receivables and account payables are handled efficiently; also tells about whether the asset utilization is appropriate.
• Solvency Ratios – Debt repayment capacity of the company; could be critical for some of the companies
• Profitability Ratios – margins earned and return on assets and equity
• Valuation Ratios – how is the market valuing the company measured largely through relative valuation ratios

Once you have linked ratios sheet in place, you could look at the same from time to time to help you guide if you’re going in the right direction or not. In case, you’re unsure about how to check, always try to take a comparative time series analysis into account and check the performance over the years. In some cases, looking at more than one ratio together could tell loads about the company. For example, looking at the accounts receivable turnover, accounts payable turnover and inventory turnover in conjunction with each other could actually provide insights into the big picture of where the possible issues could be as far as the organizational value chain is concerned.

Most of the people who study or read about ratio analysis don’t realize how powerful it could actually get, especially when you apply it in dynamic context of financial modeling. It serves two clear purposes: firstly, it acts as a sanity check to the model’s sanctity. Sometimes, when financial modeling involves many linkages, some of the linkages are misapplied resulting in a situation where you don’t realize you have made a mistake. As difficult as it is to verify all linkages, it is impractical to keep doing that all the while the model is being constructed.

With financial ratios linked to the proforma forecasting sheets, one can easily make sure that the model is going in the right direction, and any wrong linkage would lead to one of the ratios being out of line with the others or out of line compared to other years. An example in this regard could be a situation where you have prepared the proforma income statements for 5 years, and coming down from the Profit before tax level to Net profit levels, accounting for taxation. If the company is projected to have a loss before taxation in one of the years projected and the formula is subtracting the taxes from profit before tax levels, it would create a mess in your spreadsheet, which could be overlooked.

If you had linked the ratios to the P&L previously, you would see some inconsistency on the net profit margin figure in that particular year compared to other years, and then you can go back to check if how you calculated the figure was correct.