October 10, 2020

Financial Ratios You Should Know

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Financial Ratios You Should Know

The financial ratios of the enterprise allow determining its current state, opportunities, and problems. These ratios are compared with the standards or with the average performance of other enterprises in the industry. Coefficients that go beyond the standard values signal the company’s “weak points”.

This valuable information is then used to develop a strategy and make management decisions. Investors, shareholders, and business owners are also interested in financial ratios. Therefore, each company needs a specialist who, based on the data from the reports, is able to form adequate conclusions based on the results of activities and forecasts.

What does the analysis of the financial ratios give?

Analysis of financial ratios is one of the methods for assessing the state of the enterprise and its possibilities in the future. It acts as the basis for strategic planning, helps managers identify opportunities for further development, finds the strengths and weaknesses of the company. Analysis of financial ratios is carried out to find the best ways to achieve an increase in the company’s profitability.

The analyst must understand the variety of figures from accounting and management reporting in order to determine how efficiently the enterprise is operating. In financial analysis, the main thing is not the calculation of these ratios, but the correct interpretation of the results obtained. 

It should be noted that the system of financial ratios is not a crystal ball in which you can see everything that was and what will be. It’s just a convenient way to summarize a large amount of financial data and compare the performance of different companies and performance from year to year.

Main groups of financial ratios

More than 200 ratios are used in financial analysis. All of them characterize 4 main aspects of the company’s activity: liquidity; asset turnover; profitability; market value. These may differ depending on the analysis purpose and the users for whom this information is intended. Today, we will review the basic ratios of each group.

Top 3 Liquidity Ratios

Let’s start with the three basic liquidity ratios. These three numbers give a complete understanding of the liquidity of the enterprise.

  • The most popular among all ratios, the current liquidity ratio, is used primarily by investors in assessing the liquidity of an enterprise.
  • The absolute liquidity ratio is interesting for suppliers. It shows the ability of an enterprise to pay off money owed to suppliers.
  • The quick liquidity ratio is calculated by lenders to assess the quick solvency of an enterprise when issuing loans.
Financial Ratios You Should Know

Top 3 Leverage Ratios

There are several different ratios to use in order to assess the leveraging of a company. They give more information about company’s capital structure, financial obligations, and its ability to clear these obligations.

  • The debt-to-equity ratio characterizes the stability of the company in relation to its debt obligations. The lower ratio is considered preferable, although if it is too low, it might show excessive caution. Bankers and investors are primary users of this ratio.
  • The interest coverage ratio shows how large a company’s income reserve is to ensure payments related to the cost of borrowed loans (interest). This indicator should be more than 1, but specific recommendations depend on many circumstances. Bankers and other lenders check this ratio.
  • The debt-to-tangible net worth ratio is useful when it is important to understand how many physical assets a company has. It represents the proceeds that could be available if the company were to be quickly sold. If the ratio is greater than 1, then attention should be paid to how a company is managing its financing activities.

Top 3 Profitability Ratios

Let’s move on to looking at the three most important profitability ratios. These ratios show the effectiveness of cash management in the enterprise. Financial statements are the main source of information for calculating these ratios.

  • The return on assets ratio (ROA) is used by financial analysts to evaluate enterprise performance in terms of profitability. The ratio shows the financial return on the assets of the enterprise.
  • The return on equity ratio (ROE) is of interest to business owners and investors who receive dividend payments from the company. It shows how effectively the money invested in the company was used.
  • The return on sales ratio (ROS) is used by the head of sales, investors, and the business owner. The ratio shows how good a company is at selling its products. It also allows you to determine the share of the product costs in sales. It should be noted that it is not important how many products the company sold, but how much net profit it earned from these sales.
Financial Ratios You Should Know

Top 3 Efficiency Ratios

Let’s move on to looking at the three most important business efficiency ratios. The difference between this group of indicators from the group of profitability indicators lies in the fact that they show the non-financial efficiency of the enterprise.

  • The accounts receivable turnover ratio is used by the CEO, marketing managers, sales managers, CFO, and finance managers. The ratio shows how effectively the interaction between the company and counterparties is built.
  • The accounts payable turnover ratio is used primarily to determine ways to increase the liquidity of the enterprise and is interesting for the owners and creditors of the enterprise. It shows how many times in the reporting period the company has paid off its debts to creditors.
  • The inventory turnover ratio can be used by the business manager and sales managers. It determines the effectiveness of inventory management in an enterprise.
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Author: Charles Lutwidge

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