Most financial metrics are derived from the income statement and balance sheet. A balance sheet is a snapshot of a company’s financial condition at a point of time. The income statement states the profit, earnings or loss statements, usually on quarterly and annual basis. Financial ratios explain the trends of a company and summarize a firm’s financial statement used in generating other reports (Bull, 2008). The most common used ratios include asset management, financial leverage, liquidity, profitability and market value and are discussed below.
Liquidity ratios
These ratios are used in measuring a company’s ability to pay its short term debts or liabilities. The commonly used liquidity measure is the current ratio and the quick test ratio. Current ratio is a measure of currents assets to current liabilities. A high rated current ratio indicates that a company is capable to cover its liabilities and conversion of long term assets is unlikely in the foreseeable future. However, a high current ratio may also indicate inefficiency in maximizing the use of cash balance or holding excessive inventories in the form of cash (Golden, Skalak, Clayton and Ebooks Corporation, 2006).
Quick or acid test ratio provides information on a company’s ability to meet its liabilities with the current assets. The limitation in this ratio is that it does not include the inventories, therefore, cannot be used in emergencies. Inventories may take a long time to be liquidated or in cases of emergency, they are discounted; this implies that they represent an under value of the assets. Quick ratios, therefore, are not efficient in assessing the capability of an organization and managers can only use them as a complement to the current ratios.
Asset management ratios.
This is an assessment of the utilization of assets in generating sales. The net income determines the sales and profits gained in a given financial year and measures how the available resources are used in the company. The commonly used asset management ratios are the turnover ratio and inventory turnover ratio. The total asset turnover ratio measures the efficiency of assets in generating money. The ratio is a measure of the net sales over the average total assets. The inventory ratio is used to determine the frequency of sales and replacement of company’s assets (Rachev, Stoyanov and Fabozzi, 2011). The ratio is a measure of cost of goods sold to the standard inventory. This value is considered inefficient in assessing a company’s performance and in comparison to the competitors due to the difficulties in interpretation.
Leverage ratios.
This refers to the means used in financing operations with a debt and equity evaluation. A highly leveraged company is that which relies extensively on borrowing (Bull, 2008). The commonly used leverage ratios are debt ratio and interest coverage ratio. The debt ratio is an average of total liabilities to total assets derived from a balance sheet. A low ratio is preferable since a higher ratio implies high borrowings and increased financial risks. Among other ratios, this ratio has an element of uniqueness in that lower values are preferred over higher values. The interest average ratio measures a company’s ability to pay the interests under their debts.
Profitability ratios.
These ratios are used in performance evaluation and expenditure control. The commonly used profitability ratios are net profit margin and return on equity ratio. The net profit margin ratio is a measure of net income to sales or revenues. It represents efficiency in production and operations. A low margin is an indication on poor management and inefficient operations, and this may indicate a financial risk. To draw valid conclusions from this ratio, the management needs to consider the company’s history and compare to the industry competitors. The return on equity ratio is a representation of a company’s net income to the owners’ equity. It indicates the rates to which shareholders are receiving returns from their investments (Golden, Skalak, Clayton and Ebooks Corporation, 2006).
Market value ratios.
These are quick methods used in estimating the book value of an organization. The most commonly used market value ratios include the market value ratio and price-to-earnings ratio. The former is a multiple of price per share of a common stock and the number of outstanding shares, and assesses its market value. This method is limited on price speculations on the future rather that present performance. The price to earnings ratio compares the price per share to earnings per share. It is the estimation on the amount that investors need to pay for each unit of company’s earnings. The ratio allows comparisons of market values of companies with different sizes (Rachev, Stoyanov and Fabozzi, 2011).
Usefulness to managers.
Managers use these ratios in evaluating the status and performance of a company, and in comparing a company’s performance to its market competitors. The ratios are used in making crucial decisions on information systems, manufacturing, supply chain management, pricing strategies, how to improve on competitive advantage, among many others. The ratios are also used in prospecting the future growth. With such analyses, the managers determine what to improve or develop to acquire the objective and mission of the company. The ratios also analyze the productivity measures which provide an insight on how well the company is run.
The ratios analyze the customer satisfaction base and in determining how well they are meeting the customer’s needs (Bull, 2008). The information is necessary for merchandising, asset acquisition and disposition. A measure of the asset turnover rate is useful in determining the uses and productivity of the assets and in making decisions on every asset. For instance assets with low levels of productivity may be substituted with more resourceful assets; For instance, the asset management ratio assesses the effectiveness of the available resources and company’s assets. The ratios are also applicable in loan and debts acquisitions; creditors use this information to assess the capability of a company. The lenders analyze the accounting records to determine if the operating strategies are suitable to bear the interest accruing to the loans.
External stakeholders make their investment decisions based on a company’s financial ratios. Investors use the information in classifying the best companies to invest and use their resources. From the turnovers and share prices the investors determine the capability of a company, its prospected growth and mission (Rachev, Stoyanov and Fabozzi, 2011). This helps them in making decisions on whether to invest their resources and finances to the company or whether to withdraw from investing in the company. Markets also use the information in determining the level of competition that the company imposes in the market. The information is also crucial in pricing strategy of other companies and creation of price floors and ceilings to avoid unnecessary competitions.
Government regulators.
The financial ratios determine the profit margins of companies. This is useful to the government regulators in determining taxation values and interests on debts. The incomes and ratios assist in the monetary and fiscal policy measures. From the analysis, the government can measure the amounts of money in circulation and put measures to control inflation and recession (Golden, Skalak, Clayton and Ebooks Corporation, 2006). The amount of profits and ratios is also used in taxation whereby companies with higher ratios are taxed more than those with smaller margins. The government also uses the financial metrics in determining the companies that are worth in issuing debts and grants. For instance companies with high turnovers may indicate capability to repay loans while companies with low rates may qualify for grants.
Recommendation to managers, investors and government regulators.
Among the financial metrics and ratios, profitability ratios can be considered to suit the needs of managers, government regulators and investors. This is because; the ratios provide the revenue levels of a company that can be used by managers in assessing the company’s performance (Rachev, Stoyanov and Fabozzi, 2011). The ratios provide the resourcefulness of the assets, and from this information, the managers can assess productivity. Profitability ratios are also suitable in comparing a company’s competition strength in the market and from this analysis; the managers determine their points of strengths and weaknesses.
The ratios are used by investors in determining if a company is worth their resources. From this analysis, the investors measure the equity turnover and the profits that they expect from their equity. Government authorities also use this ratio to determine the levels of taxation and in lending decisions. The authorities use the information to analyze market systems and in GDP determination (Bull, 2008). The ratio provides the necessary information that managers, investors and government regulators require in assessing the value of a company.
Reference.
Bull, R. (2008). Financial ratios: How to use financial ratios to maximize value and success for your business. Oxford: CIMA.
Golden, T. W., Skalak, S.L., Clayton, M. M., & Ebooks Corporation. (2006). A guide to forensic accounting investigation. Hoboken, N.J: J. Wiley.
Rachev, S. T., Stoyanov, S. V., & Fabozzi, F. J. (2011). A Probability Metrics Approach to Financial Risk Measures. Hoboken: John Wiley & Sons.
