Financial Ratios

Sandeep Goel

• Editorial: Business Expert Press
• Año: 2015
• ISBN:
  9781631573606
• Categoría: Business
• Categoría: Finance

Financial ratios are an important technique of the financial analysis of a business organization. Effective financial management is the key to running a financially successful business. Ratio analysis is critical for helping you understand financial statements, for identifying trends over time, and for measuring the overall financial health of your business. Lenders and potential investors often rely on ratio analysis for making lending and investing decisions. This book aims to not only develop an understanding of the concepts of financial ratios but also to provide the students a practical insight into the application of financial ratios for decision making and control. It analyzes the financial statements of corporate enterprises in India in diverse sectors with the help of financial ratios in order to facilitate the learning process.

PART I

Introduction

Chapter 1

Nature of Financial Ratios

The Present Chapter

This chapter discusses the concept of financial ratios with their types, importance, and objectives.

Financial Ratios: Overview

“Ratio analysis” is an important technique of financial statement analysis. Financial ratios are useful indicators of a firm’s performance and financial situation. They are important tools that help in judging the ­profitability, efficiency, liquidity, and solvency of an entity. They help in analyzing the trend of the firm’s growth over the years. They are also helpful in ­forecasting and enabling management to set specific goals that are realizable.

It is important to choose financial ratios that are applicable to the business at hand. There are hundreds of financial ratios available, some of which apply to all businesses and some of which are industry specific.

Different users such as bankers, creditors, investors, and regulators use ratios to analyze the financial situation of the company for their ­decision-making purpose. Based on the results, bankers and creditors decide to lend, or not, and potential shareholders choose to invest in a company.

Financial ratios are classified according to the objective of analysis. The following types of ratios are commonly used:

• Profitability ratios
• Efficiency ratios
• Liquidity ratios
• Solvency ratios
• Market ratios

Types of Financial Ratios

• Profitability ratios
  The ultimate objective of a firm is profitability. The ­purpose of these ratios is to see if a business is being efficient with its ­expenditures to create products that can be sold at reasonable prices. Profitabi­lity ratios help in determining the overall ­effectiveness of management regarding returns generated on sales and investments.
  Profitability ratios are used to determine the profit capacity of the firm at different levels. That is why there are several measures to analyze the success of the firm at generating profits.
• Efficiency ratios
  Efficiency ratios or asset turnover ratios indicate how efficiently the firm utilizes its assets. They are also referred to as “efficiency ratios,” asset utilization ratios, or asset management ratios. Two commonly used asset turnover ratios are receivables turnover and inventory turnover.
  High rates of turnover for receivables and inventory indicate that a company is maximizing its use of cash by having ­minimal assets outstanding in these areas. Conversely, a low payable ­turnover rate is considered better, since it implies that a business is maxi­mizing the loans extended to it by its suppliers via ­outstanding invoices.
• Liquidity ratios
  Liquidity ratios provide information about a firm’s ability to meet its short-term financial obligations. They are of immense use to those extending short-term credit to the firm. Two frequently used liquidity ratios are the current ratio (or working capital ratio) and the quick ratio.
  The main purpose of liquidity ratios is to see if a business has enough assets that can be easily converted into cash to meet its current obligations.
• Solvency ratios
  Solvency ratios or financial leverage ratios indicate the long-term soundness of the firm. The relative debt load of a business is its “leverage.” Financial leverage ratios measure the extent to which the firm is employing long-term debt and what is the degree of financial risk of the firm?
  A high degree of solvency indicates that a company’s cash flows are consistent enough to make periodic interest and principal ­payments on its debt. In practice, bankers often include leverage ratios as debt covenants in contract agreements. Bankers want to ensure that the entity can operate during difficult financial periods.
• Market ratios
  Market ratios provide an insight into the market trend of the firm and the prospects for future growth. Two commonly used ratios are the book value per share and the price–earnings ratio.

Significance of Financial Ratios

1. Financial position. Financial ratios are useful indicators of a firm’s performance and financial situation. They help various users such as investors, management, and bankers in decision making about the firm they are dealing with.
2. Evaluates efficiency. These ratios are important for judging the company’s efficiency in terms of its operations and management. They determine how well the company has been able to utilize its assets and earn profits.
3. Meaningful. Ratios make the information in financial statements more meaningful. They highlight important information in a simple form quickly. A user can judge a company by just looking at few numbers instead of reading the whole financial statements.
4. Trend analysis. Ratios through trend analysis reveal whether the financial position of the firm is improving or deteriorating over the years...