Financial ratios measure the relationship between two or more components of financial statements.
They are useful tools that help business managers and investors analyze and compare financial relationships between the accounts on the company’s financial statements.
Thus, financial ratios make financial analysis possible across a company’s history.
Furthermore, financial ratios enable the stakeholders to evaluate their company’s performance and compare it with other similar businesses in their industry.
They are used most effectively when results over several periods are compared. This allows an organisation to evaluate their performance over time and uncover signs of trouble.
Therefore, financial ratio analysis is a quantitative tool that business managers use to gather valuable insights into an organisation’s profitability. It also provides insights on solvency, efficiency, liquidity, coverage, and market value.
WHY FINANCIAL RATIO ANALYSIS?
The primary aim of analysing an organisation’s financial statement is to assess the organisation’s;
- Liquidity position
- The extent of debt and equity financing
- Efficiency in the use of resources.
In other words, the main importance of financial ratio analysis is that they provide good ways to measure your company’s financial health at a given time.
TYPES OF FINANCIAL RATIOS FOR COMPANIES
There are a number of different financial ratios that can be calculated, measured and monitored.
However, financial ratios are usually grouped into five categories, namely:
- Liquidity ratios
- Leverage (or gearing) ratios
- Activity ratios
- Profitability ratios
- Investors ratios
We will be looking at liquidity ratios used to assess business performance in this post.
The liquidity ratio measures the ability of the organisation to meet its short-term obligation.
In other words, it evaluates if an organization can pay its short-term maturing debt.
Under liquidity ratio, there are several ratios for checking how financially sound a company is.
Among them are the Current ratio and the Acid test ratio.
The current ratio measures the extent to which a firm’s current assets can cover its short-term debt.
It measures the capacity of the firm to settle its short-term obligation.
So, the formula for calculating the current ratio is:
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑟𝑎𝑡𝑖𝑜= 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠/𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
Current assets are assets that can be converted to cash within one year such as cash, cash equivalent, accounts receivable, short-term deposits and marketable securities.
The current liabilities refer to the business’s financial obligations that are payable within a year.
Therefore, a good current ratio is between 2:1. This means the business has 2 times more current assets than liabilities to cover its debts.
A current ratio below 1 means that the company does not have enough liquid assets to cover its short-term liabilities.
The ratio measures a firm’s capacity to pay its short-term debt without recourse to selling its inventory (otherwise known as stock).
The acid-test ratio is also known as the quick ratio.
The formula for calculating the Acid test ratio is:
𝐴𝑐𝑖𝑑−𝑡𝑒𝑠𝑡 𝑟𝑎𝑡𝑖𝑜=𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠−𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦/𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
The usual industry norm is for a firm to have 1:1. Which indicates that the firm’s current assets should equal its liabilities.
Businesses with an acid test ratio of less than one do not have enough liquid assets to pay off their debts.
Therefore, if the difference between the acid test ratio and the current ratio is large, it means the business is currently relying too much on inventory.
This is an indication that a firm is having a liquidity problem.
In summary, the liquidity ratio as one of the financial ratio categories plays an important role in measuring the financial stability and credibility of any company.
Thank you for reading.