Financial Ratio
Financial ratio is a financial tool that is used by a business firm to show the relation between the different kinds of financial transactions and to compare with previous data to measure a firm’s financial situation or performance.
It shows the differences between financial transactions conducted by a business firm in two different accounting periods.
In short, a financial ratio takes one number and divides it into another number to determine a decimal that can later be converted to a percentage, if desired.
Importance of Financial Ratios
To measure profitability position of a business firm.
To highlight the degree of efficiency of a company in the management of its assets and other resources.
To ensure suitable liquidity to meet a firm’s short term liabilities or obligations.
To compare with the industry standards to get a better understanding of its financial health and fiscal position.
To validate or disprove the financing, investing, and operating decision of the firm.
To simplifies complex accounting statements and financial data into simple ratios
identify problem areas and bring the attention of the management to such areas To analyze financial statement for the suitable financial management
Limitations of Financial Ratios
Ratios ignore the price level changes due to inflation.
Accounting ratios completely ignore the qualitative aspects of the firm
There are no standard definitions of the ratios
Accounting ratios do not resolve any financial problems of the company
Such Ratios are based on historical data since it does not represent future of a firm’s financial performance.
Changes in accounting policies affect the ratios and difficult to compare
Information may be manipulated by a firm to report a better result than its actual performance.
Misleading conclusions about the company performance and future prospects due to operational changes.
Quick Ratio = CA-Inventories/CL*100
Loans to Deposit Ratio = Loans / Deposits * 100
Solvency Ratio: It is also known as leverage ratio that are used to identify proportion of debts compared to its equity, fixed assets, earnings of the company etc. These ratios calculate if the company can meet its long-term debt. It is calculated as follows;
Debt equity ratio = Long term debt/ Shareholders equity
Debt to assets ratio = Total debt/ Total assets
Property or equity ratio = Shareholders fund/ Capital employed
Interest coverage ratios = Net profit before interest and tax/ Interest on long term debt
Assets management ratio: In order to find out how successfully, an enterprise is utilizing its assets to generate revenue this ratio is used by enterprises. It can be calculated as follows;
Inventory turnover ratio = Cost of goods sold/ Inventories Assets turnover ratio = Sales Revenue/ Total assets
Market value ratio: Market value ratios are used to evaluate the current share price of enterprises. These ratios are used by enterprises to attract current and potential investors. Market value ratios are calculated as follows;
Book value per share = Total equity/ Total Number of shares
Dividend yield = Total dividend/ Market price of the stock
Earnings per share = Total earning/ Total Number of share
Market value per share = Total market value of shares/ Total Number of share Price earnings ratio = MPS/ EPS
Financial Ratios make easy to understand the financial performance of a business firm by showing the relationship of different financial transactions that helps to make sound and rationale financial decisions for the improvement of future financial health of a business firm.
