Understanding Financial Ratios

Seun Igbalode Written by Seun Igbalode · 2 min read >

Prior to enrolling at the Lagos Business School, the only financial concept I understood, apart from profit and loss, the Time Value of Money. It was practically impossible for me not to know about this concept given the obvious importance my boss attached to it and the way he emphasised it as being crucial to the success of any business at the slightest of opportunities.

The Time Value of Money concept revolves around the fact that money is worth more now than it will be in the future given, given that the money will erode in value due to factors such as inflation and economic contraction etc. In simple terms, the earlier we are able to get our account receivable in, the better.

As a consultancy, we sell ‘intangible’ products. The Corporate and Financial Accounting course which is for the first-year students of the EMBA course has however exposed me to the importance of financial numbers. It is pertinent to keep accurate records for every financial transaction. An analysis would reveal the cost centres, to see where the money is spent and its impact on the bottom line.

Financial Ratios

One tool which can help the business leadership can utilise in financial analysis is the financial ratio. Financial ratios are tools that are employed in gathering valuable insights about an organisation’s profitability, the extent of efficiency in utilising resources, the level of liquidity as well as market value, amongst other indices.

Ratio analysis is conducted by using the data contained in the firm’s balance sheet, income statement, and statement of cash flows. The information gathered from financial ratio analysis is often used by the firms to make financial decisions for the business and other stakeholders such as current and prospective investors, to enable them to assess the financial health of the business.

Financial ratios are however only useful if there is a basis of comparison for them. Each ratio should be compared to past time periods of data for the business. Others also adopt the practice of comparing the data of the firm’s financial ratios with that of other firms within the same industry.

Types of Financial Ratios

There are six types of financial ratios namely: liquidity ratios, efficiency ratios, solvency ratios, coverage ratios, market value ratios and profitability ratios.   

Liquidity Ratios

Liquidity ratios are used to determine whether a business entity can meet its current debt obligations with its current assets. Three types of liquidity ratios that are used in gauging the company’s debt liquidity are the Working capital ratio, the Quick ratio and the Cash ratio.

Efficiency Ratios

Efficiency ratios are used to determine how efficiently the organisation is utilising its assets to generate sales and maximise profit. Efficiency ratios measure the efficiency of the firm’s operations. Types of efficiency ratios are Inventory Turnover Ratio, Days Sales Outstanding, Fixed Assets Turnover Ratio and Total Assets Turnover Ratio.

Solvency Ratios

Solvency ratios gauge how much debt financing the firm uses as compared to either its retained earnings or equity financing. There are two major solvency ratios are total debt ratio and debt-to-equity ratio.

Coverage Ratios

The coverage ratios measure the extent to which a business firm can cover its debt obligations and meet the associated costs. Two types of coverage ratios are times interest earned ratio and debt service coverage ratio.

Profitability Ratios

Profitability ratios are a class of financial metrics that are used to assess a business’s ability to generate earnings relative to its revenue, operating costs, balance sheet assets, or shareholders’ equity. Four types of profitability ratios are Net Profit Margin, Return On Total Asset, Basic Earning Power and Return On Equity.

Market Value Ratios

Market Value Ratios are usually used calculated for publicly held firms. Three types of primary market value ratios are Price/Earnings Ratio, Price/Cash Flow Ratio and Market/book ratio.

Financial ratios are best used in setting goals for high performance, utilised to analyse a firm’s performance across periods of time and useful to compare performance of firms across industries.

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