Financial Ratio Analysis

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Financial Ration Analysis

Financial Ratio AnalysisImage result for financial ratio analysis in strategic management diagram

Financial ratio analysis identifies the relationship between two financial variables in order to derive the meaningful conclusion about their behaviour. Metcalf and Tigard have defined financial ratio analysis as “a process of evaluating the relationship between component parts of financial statements to obtain a better understanding of a firm’s position and performance.The type of relationship to be investigated depends on the objective and purpose of evaluation. In the case of measurement of overall performance, generally, four groups of ratios are considered: liquidity ratios, activity ratios, leverage ratios, and profitability ratios. A brief description of these ratios is presented here.

Liquidity Ratios

Liquidity ratios indicate the organisation’s ability to pay its short-term debts. These ratios are generally expressed in two forms: current ratio and quick ratio. Current ratio shows the relationship between current assets and current liabilities. This indicates the extent to which current assets are adequate to pay current liabilities. The quick ratio indicates the relationship between liquid assets (cash in hand and with the bank and short-term debtors) and current liabilities. It helps in identifying the organisation’s ability to pay its current liabilities without considering inventory in hand.

Activity Ratios

Activity ratios show how funds of the organisation are being used. These ratios are in the form of inventory turnover ratio, receivable turnover ratio, and assets turnover ratio. Inventory turnover ratio indicates the number of times inventory is replaced during the year and shows how effectively inventory has been managed. The receivable turnover ratio shows how promptly the organisation is able to collect dues from its debtors. Assets turnover ratio indicates how effectively assets have been used to generate sales.

Leverage Ratios

Leverage ratios indicate the relative amount of funds in the business supplied by creditors/financiers and shareholders/ owners. These ratios are in the form of a debt-equity ratio, debt total capital ratio, and interest coverage ratio. The debt-equity ratio indicates the proportion of debt in relation to equity and indicates the financial strength of the organisation. The debt-total capital ratio shows the proportion of debt to total capital employed. This also indicates the financial strength. Interest coverage ratio shows the interest burden being borne by the organisation in relation to its profit.

Profitability Ratios

Profitability ratios show the ability of an organisation to earn a profit in relation to its sales and/or investment. Profitability ratios are expressed in terms of profit margin as well as return on investment. Profit margin, either net profit or gross profit, is expressed in the form of relationship between profit and sales and indicates the degree of profitability of the business. Return on investment is measured by relating profit to investment. Return on investment is the most comprehensive technique for controlling overall performance. Therefore, the somewhat more elaborate discussion is presented.