Financial Ratio Analysis as a Tool for Financial Performance Measurement
Ratios derived from the financial statements of firms are important management tool. Like a person’s vital statistics, heart rate, cholesterol level, blood pressure, etc. ratios can provide valuable insights into and empirical support for strategic issue surrounding firms. A ratio is a mathematical relation between one quantity to another. Ratios can be classified according to the way they are constructed and their general characteristics. By construction ratios can be identified as:
· Coverage ratio – is a measure of a company’s ability to satisfy particular obligations
· Return ratio – is a measure of the net benefit, relative to the resources expended
· Turnover ratio – is a measure of the gross benefit, relative to the resources expended
· Component percentage – the ration of a component of an item to the item
There are six aspects of operating performance and financial condition that can be evaluated using financial ratios. These are:
· Liquidity Ratio – liquidity reflects the ability of a company to meet its short-term obligations using assets that are most readily converted into cash. Assets that may be converted into cash in a short period of time are referred to as liquid assets, they are listed in the financial statements as current assets. Current assets are often referred to as working capital because these assets represent the resources needed for the day-to-day operations of the company’s long-term, capital investments. Current assets are used to satisfy short-term obligations, or current liabilities.
· Profitability Ratio – profitability ratios compare components of income with sales. They give the users an idea of what makes up a company’s income and are usually expressed as a portion of each dollar of sales. The gross profit margin is the ratio of gross income or profit of sales. The operating profit margin is the ratio of operating profit to sales. This is a ratio that indicates how much of each dollar of sales is left over after operating expenses. The net profit margin is the ratio of net income to sales, and indicates how much of each dollar of sales is left over after all expenses.
· Activity Ratio – activity ratios are measures of how well assets are used. Activity ratios – which are, for the most part, turnover rations – can be used to evaluate the benefits by specific assets, such as inventory or accounts receivable. Or they can be used to evaluate the benefits produced by all a company’s assets collectively. These measures help the user gauge how effectively the company is at putting its investment to work. A company will invest in assets and then use these assets to generate revenues. The greater the turnover, the more effectively the company is at producing a benefit from its investment in assets.
· Financial Leverage Ratio – a company can finance its assets either with equity or debt. Financing through debt involves risk because debt legally obligates the company to pay interest and to repay the principal as promised. Equity financing does not obligate the company to pay anything – dividends are paid at the discretion of the board of directors. There is always some risk, which is referred to as business risk, inherent in any operating segment of a business. But how a company chooses to finance its operations – the particular mix of debt and equity – may add financial risk on top of business risk. Financial risk is the extent that debt financing is used relative to equity. Financial leverage ratios are used to assess how much financial risk company has taken on. There are two types of financial leverage ratios: component percentages and coverage ratios.
· Shareholder Ratio – these ratios translate to the overall results so that they can be compared in terms of a share of stock.
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