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Corporate Financial Accounting – part 4

Adeyemi Adegbite Written by Adeyemi Adegbite · 1 min read >

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Background

In this session, I will be discussing financial ratio and its uses in analyzing business performance. We will be using a company’s financial records to drive home the learnings. Amongst the ratios to consider include: profitability ratio, liquidity ratio, efficiency ratio, capital structure ratio and market ratio.  

Profitability Ratio

The profitability ratio is made up of ratios like Gross margin, operating income margin, net profit margin, return on asset and return of equity. The Gross margin is the difference between the net sales and the cost of goods sold. While the operating income margin is defined as the difference between the gross margin and the operating expenses plus the Selling, General and Administrative expenses. The net profit margin speaks to the difference between operating income and taxes and interest expenses.

Furthermore, the return on asset measures extend of profit a company’s asset is able to generate. It is usually measure by a ratio of the net income to the average total asset. It can also be said to be the product of a company’s productivity and its profitability. In addition, return on equity speaks to the equity contributors about how profitable has been their equity investments. It is a ratio of net income to the average shareholders’ equity.

Liquidity Ratio

Some of the ratios under liquidity ratio include current ratio, quick ratio and cash ratio. This ratio basically measure the easy at which a company can liquidate its asset to offset its liability or debts. Current ratio is the ratio between current assets to current liabilities. The current assets is usually made up of cash, inventories, receivables (account or notes) and any other short-term assets. While current liabilities include: short-term debts, payables (account or note) deferred taxes among others.

Meanwhile, quick ratio is very similar to current ratio but without inventories. To put it clearly, quick ratio considers a ratio between current assets less inventories to current liabilities.

Efficiency Ratio

Under efficiency ratio, some of the considerations include: asset turnover, stock turnover, receivable conversion period among others. The asset turnover talk about how well the asset of a company was sweat to achieve net sales. In measurement it is the ratio of net sales to total asset. The stock turnover speaks to how quickly a company consumes its inventory or stock and replenishes. It is the ratio of cost of goods sold to average inventory. The higher the ratio the better for a company. A company that has a stock turnover of 4 means that it clears its inventory in 3 months while a stock turnover of 3 means the company clears its inventory in 4 months.

Capital Structure Ratio

The capital structure ratio are made up of Equity multiplier and debt-to-equity ratios.  The capital structure ratio provides information about how the assets of a business is catered for. Is it financed using equity or debt? The equity multiplier is a ratio of total assets to total shareholders’ equity. A ratio of 2 suggests that the assets of a company is financed 50% using equity and 50% debt. A lower value mean the assets is financed largely by equity, which is a preferred option for many.

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