The primary source of a financial ratio is the financial statement of the company which comprises of the statement of profit/loss and other comprehensive income, statement of financial position, statement of cashflow and Equity statement. The financial ratio plays an important role in examining the financial health and offering insights on the overall performance of the company. Financial ratio enables the stakeholders of the company to know the financial standing/status of the company, addressing questions such as its liquidity, the proportion of debt used to finance assets in comparison to shareholders’ equity, reliance on debt for operations, inventory turnover, and aids in making informed decisions about the profitability, liquidity, solvency and efficiency of the company.
Primary objectives of analyzing a financial ratio:
- Financial ratio aids to track company’s performance
Examining individual financial ratios for each period or over a period of years and monitoring the evolution of their values over time is undertaken to identify emerging trends within a company. For example, a reducing inventory turnover indicates that the company is experiencing bottlenecks in selling off its products (weak sales) whereas an increasing inventory turnover indicates the company has a strong sales.
- Financial ratio facilitates the comparison of the company’s performance
Financial ratios assist in comparing the company’s performance not only with its competitors but also against industry standards. A company can outperform its competitors while still falling short of meeting industry ratios. For example, a comparison of the debt-to -equity ratio across companies in the same industry helps investors and analysts understand how companies manage their capital structure. It provides a basis for evaluating the potential risk and return associated with each company, aiding in investment decisions.
Analyzing financial ratios can be broken down into various component, with each component highlighting a specific aspect of the company’s financial health.
- Liquidity ratio
This ratio provides insights into a company’s short term financial health, it assesses the company’s ability to meet its short-term financial obligation by measuring its ability to quickly convert asset to cash and cover up its immediate liabilities. A higher liquidity ratio is favorable as it indicates the company has a strong ability to meet its short-term obligations, although an excess liquidity may also indicate underutilization of the company’s asset. A decision as to whether the ratio is high or low will depend on the industry standard. Some liquidity ratios include
–Current ratio: This ratio compares the current asset of a company to its current liability.
The formula: Current Asset/current Liability
–Quick ratio/Acid Test ratio: This ratio is a more accurate measure of the liability of a company because it excludes the inventory from the current asset.
The formula: Current asset -inventory/ Current Liability
Profitability ratio
This ratio assesses the company’s ability to generate profit in relation to its revenue, assets, equity and other financial metrics, it provides insights into the efficiency and effectiveness of the operations and management of the company. It is important to investors and analyst as it assess a company’s financial performance, efficiency, and its ability to generate returns for investors. A high profitability ratio is favorable for the company as it indicates that there’s an efficient production and pricing of goods, efficient operation and cost management, efficient utilization of the shareholders equity in generating profit. Some profitability ratios include:
-Gross Profit Margin:
This ratio shows the company’s ability in producing goods and service efficiently and is calculated as Gross profit/Revenue *100, The gross profit indicates the percentage of profit derived after deducting the cost of goods sold for the period. A high gross profit margin ratio indicates efficient production and pricing of goods.
-Net Profit Margin:
This ratio shows the efficiency of the company in operations and cost management .it is the percentage of profit earned by the company after all other expenses have been deducted such as administrative expense, operating expense, selling expense.
The formula: Net profit/ Revenue *100
– Return on Equity:
This ratio measures the company’s efficiency in utilizing its shareholders equity in generating profit.
The Formula: Net income/Shareholders equity *100
–Return on Asset:
This ratio measures the company’s efficiency in utilizing its asset in generating profit
The formula: Net income/ Total Asset *100
- Solvency ratio
Solvency ratios are key financial indicators used to evaluate a company’s sustained financial health and its capability to fulfill long-term debt commitments. These metrics offer valuable insights into the company’s overall financial well-being, the potential for insolvency, and its resilience in navigating economic downturns. Common solvency ratios encompass various measures that provide a comprehensive view of a company’s ability to meet its long-term financial obligations. Some solvency ratios include;
-Debt to Equity ratio:
This ratio measures the proportion of a company’s financing that comes from debt in relation to it shareholders equity. A high debt to equity ratio is not favorable for a company as it indicates that there is a great reliance on debt for its operations which translates to higher risk involved.
The Formula: Total Debt/ Shareholders equity
-Interest Coverage ratio:
This ratio assesses the company’s capacity to offset its interest expenses through its operating income. A higher interest coverage ratio indicates the company has a greater ability to meet its interest obligation.
The Formula: Operating Income/ Interest Expense
-Debt Ratio:
This ratio examines the percentage of a company’s assets that are funded through debt. It provides a measure of the company’s leverage, indicating the extent to which it relies on debt for asset financing. A high Debt ratio is not favorable for a company.
The Formula: Total Debt/ Total Asset
- Efficiency ratio
Efficiency ratios are financial metrics that measure how well a company utilizes its resources to generate revenue and manage its operations. These ratios provide insights into the effectiveness and productivity of a company in utilizing its assets, resources, and capital. Some efficiency ratios include:
-Inventory Turnover ratio:
This ratio measures how many times a company’s inventory is sold and replaced during a given period of time. A high inventory turnover will indicate efficient inventory management, strong sales and faster cash conversion
The formula: Cost of goods sold/Average inventory
-Account Receivable ratio:
This ratio assesses the average number of days it takes a company to recover payment after sales, a lower receivable turnover ratio indicates an effective credit management and timely collection, which contributes to higher liquidity.
The Formula: Net Credit sales/ Average Account Receivable
-Account Payable ratio
This ratio measures the average number of days it takes a company to pay its creditors, an increase in the account payable ratio means the company takes longer days in sorting its creditors.
The Formula: Net Credit Purchase/ Average Account payable
- Market ratio
Market ratios are financial metrics that provide insights into how the market perceives a company’s performance and valuation. These ratios are used by investors and analysts to assess the company’s market value, investor sentiment, and potential for growth. it shows a company’s attractiveness in the stock market and make informed investment decisions. Some market ratios include:
-Price -to- Earnings(P/E) Ratio
This ratio compares a company’s current share price to its earnings per share (EPS). It indicates the markets expectations for future earnings growth. A higher Price to earnings ratio may indicate that investors have high expectations for future earnings growth.
The Formula: Market Price per share/ Earnings per share
-Dividend Yield
This ratio measures the annual dividend income as a percentage of the current market price per share. Investors often consider dividend yield when seeking income-generating investment, and it can indicate the financial strength and stability of a company.
The Formula: Dividend per share/ Market price per share *100
Market-to-Book Ratio
This ratio is also known as the price-to-book ratio, it compares a company’s market value to its book value. A ratio above 1 indicates that the market values the company higher than its book value.
The formula: Market Price per Share/ Book Value per Share
Financial ratios serve as a powerful tool for assessing a company’s financial performance and making informed investment decisions.
Liquidity ratios offer insights into a company’s short-term capacity to meet its obligations, while profitability ratios assess its ability to generate earnings. Solvency ratios provide a glimpse into the long-term financial stability and risk exposure of a company. Efficiency ratios unveil how effectively a company deploys its resources to generate income.
Regular monitoring and analysis of these ratios contribute to a deeper understanding of a company’s strength and weakness spotting out areas that requires out attention from the business, when a company encounters challenges, these ratios serve as a guide to pinpoint the source of issues. Analyzing these ratios over time, comparing them against industry benchmarks, and benchmarking them against peers contribute to a more nuanced understanding of a company’s position in the market, it guides investors and stakeholders in navigating the dynamic landscape of financial market. It enhances the ability to make well-informed investment decisions, formulate strategic plans, and monitor a company’s financial performance in a dynamic business environment.
