Financial ratios refer to a quantitative method that allows a company to determine its liquidity, profitability and operational efficiency. To do so, important financial documents such as income statements and balance sheets must be accurately recorded and organised. Investors and stakeholders generally use such information to compare a company’s financial viability with another. It should be noted, however, that financial ratios alone may not be the most effective in studying a company’s success. Other metrics are other important factors that need to be considered when assessing the company’s financial health. There are many types of financial ratios companies study today. This blog will consider the various types of financial ratios used to measure a business’s performance.
Why Monitor Financial Ratios in the First Place?
With profitability being the underlying goal of any business in the capitalised world, finances are an important aspect of a company. This does not simply mean having a record of finances but analysing them in various means to understand a company’s health. To ensure that companies objectively assess their financial health of a company financial ratios are used.
Financial ratios allow companies to stay on track of their accumulated debt, whether they have stockpiled too much inventory or are not gaining profits due to multiple costs. These ratios can generally be read in management reports and are heavily relied on by investors. Hence, checking financials should be done continuously to make informed decisions and keep the company’s health well.
Three Important Financial Ratios Companies Need to Monitor
While there are multiple financial ratios today, irrespective of what sector a company belongs to, there are a few mandatory financial ratios that need to be tracked. It is important to note that some are merely umbrella terms for a range of ratios and would include sub-ratios. Here are three important financial ratios prioritised in the business world today:
Liquidity Ratios
This ratio allows companies to stay atop their funds, specifically notifying the company whenever there is an indication that they are running out of it. By liquidity, the ratio considers actual monetary cash and easily convertible assets that can be used where finances are required to pay off debts, for instance. Hence, companies would generally rely on this ratio every month to ascertain whether their bills can be paid. If the ratio is 1.0 or greater it is regarded acceptable. A high ratio, however, would indicate that your capital is underused. However, what constitutes high and low ratios depends on the industry. The primary sub-ratios under this include:
- Current ratio – Also known as the working capital ratio, this measures the company’s ability to generate cash for the short term. The current ratio value is determined by dividing a company’s current assets by its current liabilities.
- Quick ratio – Similar to the current ratio, the quick ratio or the acid test ratio, considers the ability of a company to pay off immediate demands. The only difference is that quick ratio does not use inventory when it divides the current assets with the company’s current liability. If this ratio is low, it generally means that the organisation is finding it difficult to meet its obligations promptly.
Activity Ratios
Also known as efficiency ratios, activity ratios measure a company’s ability to convert production into cash or income. To an extent, this deals with the number of sales a company makes. They indicate how efficient a company’s operations are. It is often used to compare the organisation’s performance over a horizontal statement analysis or with a comparable company analysis. There are multiple types of activity ratios, some of which include the following:
- Average days Inventory – This calculates the average number of days it takes to sell inventory. The calculation for this requires the starting inventory balance to be added to the ending inventory balance, after which the total is divided by two. Average days inventory ratio is thus a great way to assess whether a company is ordering more than it should. The shorter ratio there is, the better, as it indicates that a company’s money is not tied up for a longer duration to generate revenue.
- Average collection period ratio – Also known as average days receivable, this ratio considers looks at the average number of days customers purchase your products and services. If the value is higher, the sooner a company can receive its ROI. Usually, the average days receivable is kept at 30 to 45 days, although this will depend on each sector. Businesses may attempt to increase this ratio by offering incentives or discounts that increase the number of sales.
- Cash conversation cycle – Although this may be considered similar to the previous two tattoos, the cash conversion cycle considers how fast a company can convert its cash into inventory and vice versa. Understanding this cycle allows managers to predict the average number of days the company’s cash will be tied up. If the ratio is positive, it demonstrates that your daily operations are typing up cash, requiring you to get extra financial support. A negative cash cycle indicates that day-to-day operations are moving cash quickly throughthe business, allowing you to pay off debts with no problem.
Profitability Ratios
As noted by the term itself, the profitability ratio considers how much money a company is making. This is regarded as an important ratio, especially when determining how much of a return on investment the organisation has received. While this ratio can be calculated monthly, it would be more efficient to do it annually, which clearly demarcates the profit a company has enjoy for a year. A few important profitability ratios include:
- Gross profit margin – This value is gained by subtracting direct expenses, which include the cost of goods sold from the net revenue. The value is then divided by net revenues and multiplied by 100 per cent.
- Net profit margin – This ratio finds out how much a company earns after paying taxes when comparing it to the number of sales made. If an organisaiton has a high net profit margin is an indication that it is more flexible and efficient.
Automate Financial Ratios to Eliminate Errors
Each financial ratio has a unique calculation method. If humans were to calculate these manually, the probability of errors occurring would be comparatively higher. An erroneous financial ratio will only mean the company is unaware of its actual financial status. This can severely affect a company, especially if the reality is that the organisation’s financials are worse than indicated. Most of the time, managers, stakeholders and investors take important decisions based on these ratios. Hence, instead of giving this burden to an employee, it would be smarter to invest in a robust solution with a powerful financial module would be smarter. That way, not only will you accurately understand your company’s economic viability, but with one investment, a good vendor would include various other features in its solution to optimise and streamline your overall company processors.
