Financial ratio analysis helps business owners to assess the financial performance of their business by comparing the ratios over periods. It helps to know the position of the company in the industry or to compare the performance with other companies in the industry. The ratio is a relationship between two or more items of the financial statements of the business. However, this article explains how you can use financial ratio analysis to strengthen your business.
Table of Contents
Types of Financial Ratio Analysis
The financial ratios can be categorized into four as follows:
- Profitability ratios
- Efficiency or activity ratios
- Liquidity or short-term solvency ratios
- Long-term stability or longer-term solvency ratio
- Investors’ ratios
However, the article explains how to improve the business using profitability, efficiency, liquidity, and long-term solvency ratios.
Profitability ratios
Profitability ratios measure the ability of the company to achieve its primary objective which is to create wealth for the owners. They measure the profit made against other items of the financial statements. The examples of profitability ratios include:
Return on capital employed (ROCE)
This is a fundamental ratio that measures the financial performance of your business. I.e. it measures the overall performance of the company by comparing the profit made with capital employed. It is an important tool to measure the effectiveness of the company using its funds to generate profit.
Net profit margin
This measures the percentage of each sales revenue that a company converts to net profit. It is the profit expressed as a percentage of sales. It measures the percentage of sales revenue that a company retained after deducting all operating expenses except interest and tax.
Returns on Shareholders equity (ROE)
It measures the rate of return that the owners received on their investment. It shows the percentage of profit after tax that the company generates from each dollar of shareholders’ equity. It measures the returns that a company generated on ordinary shareholders’ investment based on the current performance of the company.
Returns on total assets
This measures the profits earned by the company from every $1 invested on assets.
Efficiency or activity ratios
These ratios help to understand the efficiency of the company in utilizing its resources. Examples of efficiency ratios include:
Inventory turnover
This ratio helps the company to understand how often it takes to turn inventory into sales. The higher the number of times, the more efficient the company manages its inventory.
Inventory holding period
This ratio helps the company to understand the length of time it takes to hold inventory. It measures the average number of days or weeks or months it takes the organization to sell its finished goods. However, the shorter the period, the better for the company.
Trade receivable collection period
It helps the company to understand how long it takes its customers to pay the amount they owe. It measures how long it takes the company after selling goods on credit to collect the money.
Trade payables payment period
This measures the number of days or weeks or months it takes the company to pay its suppliers after buying goods on credits. However, the longer the period, the better for the company, but it must not be too long unreasonably.
Liquidity or short-term solvency ratios
These ratios help the company to know the ability of the company to settle its short-term obligations as at when due. Examples include:
Current ratio
This measures the ability of the company to use its currents assets to settle short-term obligations as at when due.
Acid test or quick ratio
It measures the ability of the company to use its quick assets to settle short-term obligations as at when due. The quick asset is current assets minus closing inventory.
Cash ratio
This measures the ability of the company to use its high liquid assets such as cash and cash equivalent to settling its short-term obligations as at when due.
Long-term stability or long-term solvency ratios
These ratios measure the ability of the company to settle its long-term obligations as at when due. They measure the relationship between the funds contributed by owners of the business and debt finance from outsiders. Examples include:
Gearing ratio
The ratio measures the financial risk of a business based on how the business is financed. It compares loan capital with owners’ capital to know the level of financial risk exposure to the business. However, a company financed with only equity capital is known as an ungeared company while a company with the combination of both loan and equity capital is known as a geared company.
Total debt ratio
This measures the percentage of total assets of the company financed with the debt capital.
Debt to equity ratio
It measures the percentage of debt capital to the equity capital to determine the level of financial risk exposure to the business.
Interest cover ratio
This measures the ability of the company to use the profit available to pay interest charges. However, the higher the number of times, the better for the company.
Conclusion
However, the financial ratio analysis will help you to understand the financial performance of the company. Therefore, it will help to make better decisions for the improvement of the company. The financial ratio analysis has its advantages as well as its limitation. Do the financial ratio analysis today for a better understanding of your business performance.
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Afeez is one of the founding partners of Marasas Consulting limited. He consults for both individuals and entities in the area of accounting, management, audit, tax, and investment. He has a wide range of experience both online and offline which allows him to provide relevant and timely professional advice and assistance to business owners with their accounting, tax, management, audit, and investment plans.
Afeez is a member of the Institute of Chartered Accountants of Nigeria (ICAN) and a member of the Nigerian Institute of Management (Chartered). He is a certified Google analyst and strategist. He earned his Bachelor degree in Management and Accounting from Obafemi Awolowo University, Ile-Ife, Nigeria, and earned an ordinary national diploma in Accountancy from The Polytechnic of Ibadan, Oyo State, Nigeria. He earned certification in “Excel Crash Course” and “Reading of Financial Statement” from Corporate Finance Institute, Canada.
Afeez is dedicated to helping clients achieve business success by helping them to establish solid and sound accounting, tax, and financial processes.