Understanding standard ratios is crucial for anyone involved in finance, accounting, or business management. These ratios provide a benchmark for evaluating a company's performance, financial health, and overall efficiency. But what exactly do the experts say about these ratios? Let's dive into the insights from various financial gurus and explore what they consider to be the gold standard.

What are Standard Ratios?

Before we delve into expert opinions, let's define what standard ratios are. In essence, they are quantitative measures derived from a company's financial statements—balance sheet, income statement, and cash flow statement. These ratios are used to assess various aspects of a company, such as its liquidity, solvency, profitability, and efficiency. By comparing these ratios against industry averages or historical data, analysts can gain valuable insights into a company's strengths and weaknesses.

Common Types of Standard Ratios

• Liquidity Ratios: These ratios measure a company's ability to meet its short-term obligations. Common examples include the current ratio, quick ratio, and cash ratio.
• Solvency Ratios: Also known as leverage ratios, these assess a company's ability to meet its long-term obligations. Examples include the debt-to-equity ratio, debt-to-assets ratio, and interest coverage ratio.
• Profitability Ratios: These ratios evaluate a company's ability to generate profits. Key profitability ratios include the gross profit margin, operating profit margin, net profit margin, return on assets (ROA), and return on equity (ROE).
• Efficiency Ratios: Also called activity ratios, these measure how efficiently a company uses its assets to generate revenue. Common efficiency ratios include the inventory turnover ratio, accounts receivable turnover ratio, and asset turnover ratio.

Expert Opinions on Standard Ratios

Now, let's explore what the experts have to say about standard ratios and their importance in financial analysis.

Benjamin Graham: The Father of Value Investing

Benjamin Graham, often regarded as the father of value investing, emphasized the importance of fundamental analysis in his seminal work, The Intelligent Investor. Graham advocated for using ratios to identify undervalued companies with strong financial positions. He particularly focused on ratios that indicated financial stability and a margin of safety.

Graham's Key Ratio Insights

• Current Ratio: Graham preferred a current ratio of at least 2:1, suggesting that a company should have twice as many current assets as current liabilities. This indicated a strong ability to meet short-term obligations.
• Debt-to-Equity Ratio: Graham favored companies with low debt levels, typically a debt-to-equity ratio of less than 1:1. This ensured that the company was not overly leveraged and could withstand financial downturns.
• Earnings Stability: Graham also stressed the importance of consistent earnings. He looked for companies with a history of stable and predictable earnings, as this provided a cushion against unforeseen events.

Warren Buffett: The Oracle of Omaha

Warren Buffett, a student of Benjamin Graham and one of the most successful investors of all time, shares a similar perspective on the importance of standard ratios. Buffett focuses on companies with durable competitive advantages, strong management teams, and attractive valuations. He uses ratios to assess a company's profitability, efficiency, and financial strength.

Buffett's Key Ratio Insights

• Return on Equity (ROE): Buffett places a strong emphasis on ROE, preferring companies with consistently high ROE figures (typically above 15%). This indicates that the company is effectively using its equity to generate profits.
• Operating Margin: Buffett looks for companies with wide operating margins, suggesting that they have pricing power and can efficiently manage their costs. A high operating margin provides a buffer against competitive pressures.
• Debt Levels: Like Graham, Buffett favors companies with conservative debt levels. He believes that excessive debt can increase a company's risk and vulnerability.

Peter Lynch: The Magellan Fund Maestro

Peter Lynch, the legendary manager of the Magellan Fund at Fidelity Investments, popularized the concept of investing in what you know. Lynch used a combination of fundamental analysis and common sense to identify promising investment opportunities. He also paid close attention to standard ratios to assess a company's financial health.

Lynch's Key Ratio Insights

• Price-to-Earnings Ratio (P/E): Lynch compared a company's P/E ratio to its growth rate. He looked for companies with a P/E ratio that was lower than their growth rate, suggesting that they were undervalued.
• Debt-to-Equity Ratio: Lynch also considered the debt-to-equity ratio, preferring companies with manageable debt levels. He believed that excessive debt could hinder a company's growth and profitability.
• Inventory Turnover: Lynch paid attention to inventory turnover, particularly for retail companies. A high inventory turnover indicated strong sales and efficient inventory management.

Aswath Damodaran: The Valuation Guru

Aswath Damodaran, a renowned professor of finance at NYU's Stern School of Business, is widely regarded as a valuation expert. Damodaran emphasizes the importance of using standard ratios in conjunction with other valuation techniques to arrive at a fair value for a company.

Damodaran's Key Ratio Insights

• Return on Invested Capital (ROIC): Damodaran stresses the importance of ROIC, which measures the return a company generates on its invested capital. He looks for companies with high and sustainable ROIC, as this indicates a strong competitive advantage.
• Cost of Capital: Damodaran also considers a company's cost of capital, which represents the minimum return required to satisfy investors. He compares a company's ROIC to its cost of capital to determine whether it is creating value for shareholders.
• Growth Rates: Damodaran emphasizes the importance of understanding a company's growth prospects. He uses ratios and other data to forecast future growth rates and assess the sustainability of growth.

Practical Applications of Standard Ratios

Standard ratios are not just theoretical concepts; they have practical applications in various areas of finance and business.

Investment Analysis

Investors use ratios to evaluate potential investment opportunities. By comparing a company's ratios to industry averages or historical data, investors can assess its financial health, profitability, and growth potential. Ratios can help investors identify undervalued companies or those with strong competitive advantages.

Credit Analysis

Lenders use ratios to assess the creditworthiness of borrowers. By analyzing a company's liquidity and solvency ratios, lenders can determine its ability to repay its debts. Ratios can help lenders assess the risk associated with lending to a particular company.

Performance Management

Managers use ratios to monitor and improve their company's performance. By tracking key ratios over time, managers can identify trends and areas for improvement. Ratios can help managers set targets and measure their progress towards achieving those targets.

Benchmarking

Ratios are used to benchmark a company's performance against its peers. By comparing a company's ratios to industry averages or the ratios of its competitors, managers can identify areas where their company is outperforming or underperforming. Benchmarking can help companies identify best practices and improve their competitiveness.

Limitations of Standard Ratios

While standard ratios are valuable tools for financial analysis, they have certain limitations.

Accounting Distortions

Ratios are based on financial statements, which can be subject to accounting distortions. Different accounting methods or estimates can affect a company's reported financial results and, consequently, its ratios. Analysts should be aware of these potential distortions and adjust for them when interpreting ratios.

Industry Differences

Ratios can vary significantly across industries. What is considered a healthy ratio in one industry may not be appropriate in another. Analysts should compare a company's ratios to those of its peers within the same industry to gain a meaningful understanding of its performance.

Lack of Context

Ratios provide a snapshot of a company's financial performance at a particular point in time. They do not provide the full context of the company's operations or the industry in which it operates. Analysts should consider qualitative factors, such as management quality, competitive landscape, and regulatory environment, when interpreting ratios.

Manipulation

Companies can manipulate their financial statements to improve their ratios. For example, a company may delay payments to suppliers to improve its current ratio or accelerate revenue recognition to boost its profitability ratios. Analysts should be aware of these potential manipulations and scrutinize a company's financial statements carefully.

Conclusion

Standard ratios are essential tools for evaluating a company's financial health and performance. Experts like Benjamin Graham, Warren Buffett, Peter Lynch, and Aswath Damodaran have emphasized the importance of using ratios in conjunction with other analytical techniques to make informed investment decisions. While ratios have limitations, they provide valuable insights into a company's liquidity, solvency, profitability, and efficiency. By understanding and applying these ratios, investors, lenders, and managers can make better decisions and achieve their financial goals. So, next time you're analyzing a company, remember the wisdom of these financial gurus and leverage the power of standard ratios!