Management of Finance: Ratios

Understanding Financial Ratios

Financial ratios are numerical comparisons of various aspects of a business’s finances, such as its profitability, solvency and efficiency.
They are used by management, investors, creditors and others to evaluate a business’s performance and financial position.
Ratios are calculated by dividing one financial figure by another, with the results usually expressed as a ratio, percentage or times.

Key Types of Financial Ratios

Profitability ratios gauge a company’s ability to generate profit. These include gross profit margin, net profit margin and return on capital employed.
Solvency ratios assess a company’s ability to meet its long-term obligations. Key ratios include debt to equity and interest cover.
Efficiency ratios measure how well a company is utilising its assets and liabilities. These typically include inventory turnover, debtor days and creditor days.
Liquidity ratios evaluate a company’s ability to cover its short-term debts. Crucial ratios are current ratio and quick ratio (acid test).

Benefits of Using Financial Ratios

They provide a quantitative tool for analysing and comparing a business’s performance.
Ratios allow for benchmarking, whereby company’s performance can be compared to industry standards or competitor’s performance.
They highlight financial strengths and weaknesses and help pinpoint areas for improvement.

Limitations of Financial Ratios

They are based on historical data and may not necessarily reflect a company’s future performance.
Ratios can be misinterpreted without proper knowledge of the business and the industry it operates in.
Different companies may employ different accounting policies, which may affect the comparability of financial ratios.

Financial Ratios in Decision Making

Ratios can inform management about the company’s financial health, supporting strategic decision making.
They can aid in identifying trends over time, allowing for anticipatory actions.
If targets are set for financial ratios, they can aid in performance control by continually checking whether these targets are met.

Using Financial Ratios for Financial Control

Regular monitoring of key financial ratios can reveal emerging problems or opportunities.
Variances between forecasted and actual ratios should prompt investigation and possibly corrective action.
A comprehensive system of ratio analysis and control can help ensure a business remains financially viable.