Introduction to Financial Ratios
A financial ratio is nothing but a parameter to measure the company’s financial status. Also, financial ratios compare the state of the company with different pieces of financial information. There are different ratios to measure the different parameters of the company’s status. Generally, financial ratios focuses on five main types of insights for any organization. Those five insights includes; liquidity, profitability, solvency, efficiency and valuation. There are many ratio to measure a single insight and each ratio reflects different position of company’s performance. There any different approaches to select the suitable ratio for company’s evaluation. In this article, we discuss about the following financial ratios;
- Activity Ratio
- Liquidity Ratio
- Solvency Ratio
- Profitability Ratio
- Market Test Ratio
Activity ration also known as turnover ration reflects the speed at which a company utilizes its assets. It also determines the level of investment made on the asset and the revenue that asset is generating. A better performing companies utilizes the lesser assets or rations to generate largest-possible amount of revenue. It is a fine indicator if you want to know how a company handles its assets and its management. Some of the important activity ratios are;
- Inventory Turnover Ratio
- Debtors Turnover Ratio
- Creditors Turnover Ratio
- Total Assets Turnover Ratio
- Working Capital Turnover Ratio
Inventory Turnover Ratio
Inventory turnover ratio is the relationship of cost of goods sold to average inventory. It indicates the speed at which inventory is converted into sales. A high turnover ratio indicates better efficiency in sales and a low ratio indicates inefficiency in sales or too much of stocks.
|Inventory Turnover Ratio = Cost of Goods Sold/ Average Inventory
Cost of Goods Sold = Net Sales – Gross Profit
Cost of Goods Sold = Opening Stock + Net Purchases + Direct Expenses – Closing Stock
Average Inventory = (Opening Inventory+ Closing Inventory)/2
Debtors’ Turnover Ratio
This ratio indicates the efficiency in the realization of debtor i.e. how well a company or business is recovering its receivables.. Debtors’ turnover ratio reflects the credit policy of the firm. A high debtors turnover means favorable credit policy and low ratio means the period of credit allowed is high and risky. It is also called Accounts Receivable Turnover Ratio.
|Debtors Turnover Ratio = Credit Sales/Average Accounts Receivable
Credit Sales = Total Sales- Cash Sales
Average Accounts Receivable = ( Opening Accounts Receivable+ Closing Account Receivable )/2
Creditors Turnover Ratio ( Creditors Velocity)
This ratio simply indicates the frequency of making payment to the creditor for credit purchases. High ratio indicates creditors are paid frequently for the credit transaction i.e. more settlement of the payables. Similarly, low ratio indicates that more time taken to make payment for the creditors. Low ratio either mean inefficient credit policy or liberal credit policy.
|Credit Turnover Ratio = Credit Purchases/ Average Accounts Payable
Credit Purchases = Total Purchases- Cash Purchases
Average Accounts Payable = (Opening Accounts Payable+ Closing Accounts Payable)/2
Total Assets Turnover Ratio
It establishes the relationship between total assets or gross capital employed and sales. A high ratio indicates better efficiency of management in the utilization of total assets or total funds of the business. Similarly, low ratio signifies inefficiency in the utilization of resources by management.
|Total Assets Turnover = Sales/Total Assets
Working Capital Turnover Ratio
This ratio indicates the number of times working capital is turned over during an year. A high ratio means faster turnover i.e. greater efficiency in the use of working capital. A very low ratio indicates redundant working capital or a position of ‘ under trading’.
|Working Capital Turnover Ration = Cost of Sales/ Net Working Capital
Liquidity ratio measures the short term financial position of a firm. A firm is said to be liquid when it is capable of meeting its short-term obligation in time. Liquidity ratios determine how quickly a company can concert the assets and use them for meeting the dues that arise. The higher the ratio, the easier is the ability to clear the debts and avoid defaulting on payments. Some of the important liquidity ratios are:
- Current Ratio
- Liquid Ratio
- Absolute Liquid Ratio
Current ratio is the ratio of firm’s current assets to current liabilities. This ratio measures the adequacy or inadequacy of working capital. Current assets are defined as those assets which are ultimately converted into cash within a period of one year or within the operating cycle of the firm. Current liabilities are those liabilities which are payable within a period of one year.
|Current Ratio = Current Assets/ Current Liabilities
Liquidity ratio is a strict measure of liquidity. It is the ratio of liquid assets to current liabilities. All the current assets are not equally liquid. Inventories and prepaid expenses are less liquid. Current assets excluding inventories and prepaid expenses are quick assets.
|Liquid (Quick) Ratio = Liquid Assets/ Current Liabilities
Liquid Assets = Current Assets – (Stock Prepaid Expenses)
Absolute Liquid Ratio
Absolute Liquid Ratio is a further rigorous test of liquidity. Debtors and Bills Receivable are excluded from Liquid Assets (Cash and cash equivalent) and Bank overdraft is excluded from current liabilities to calculate absolute liquid ratio.
|Absolute Liquid Ratio = ( Liquid Assets-(Debtors Bills Receivable))/(Current Liabilities – Bank Overdraft)
Absolute Liquid Ratio = (Cash + Cash Equivalents)/Liquid Liabilities