Uses of financial ratios are essential for an organization. Many ratios can be derived from the books of account to extract valuable information about the company’s financial performance. Below are the five major financial ratios and their uses for an organization.
Uses of Financial Ratios
A. Profitability Ratios
A profitability ratio shows an organization’s capacity to utilize its assets and shareholders’ equity to raise revenue from sales proceeds. Below are some profitability ratios and their importance:
1. Return on Capital Employed shows the profits a company raises using debt and equity financing.
2. Earnings per Share show the amount of money a company distributes to the investors who have bought shares.
3. Price-Earnings Ratio shows the amount of money investors are willing to pay for a company’s stock relative to past and future expected earning trade-offs.
4. Return on Equity shows how well a company raises its revenue using shareholders’ equity compared to its competitors in the industry.
5. Dividend per Share is a snapshot of the annual dividend remittable for each outstanding ordinary share relative to the market value.
6. Return on Assets shows the amount of profits that a company makes from the utilization of its assets.
7. Gross Profit Margin is a measure of a company’s future expected net income based on the gross profit margin’s strength or weakness.
8. Net Profit Margin helps investors assess a company’s capacity to raise enough revenue after accounting for expenses and its ability to contain business costs.
B. Liquidity Ratios
The liquidity ratio of a company is a measure of the capacity to pay off its current liabilities without necessarily struggling to meet all its due short-term obligations.
1. The Current Ratio shows the efficiency of a company using its current liabilities to meet its current liabilities as they fall due.
2. The Cash Ratio shows whether the cash equivalents and cash available in the organization are available to meet the short-term debt obligations that fall due.
3. Quick Ratio shows the strength of a company to settle its current obligations without the need for finances obtained from sales proceeds of inventory.
C. Debt / Leverage Ratios
These ratios are used to compare a company’s assets and equity with its debt and liabilities. The importance of these ratios depends on the ratio itself as follows:
1. The Debt to Equity Ratio shows a company’s leverage degree. In terms of per dollar, it assesses the leverage of a company seeking loan financing. A higher debt ratio implies a company is more leverage and at higher risk of defaulting payments.
2. The Debt to Assets Ratio shows the amount of company assets relative to its liabilities to assess if a company’s assets are enough to meet the monetary needs of investors or creditors.
3. The Debt to Capital Ratio is used to measure the degree of leverage of a company by comparing the total capital raised by the shareholders or the owners and comparing this total capital with the company’s debt obligation.
D. Activity Ratios
1. The Accounts Receivables Turnover Ratio assesses the company’s efficiency in claiming back the sum given as credit by considering the time a company takes to recover such debts.
2. The Assets Turnover Ratio measures the efficiency of a company in raising revenue from sales proceeds using its average total assets.
3. The Working Capital Ratio shows the efficiency of a company in using its current liabilities to meet its current liabilities as they fall due. This ratio is also called the current ratio.
4. The Inventory Turnover Ratio shows the frequency the company sells its inventory and replaces the sold inventory with new inventory. This helps to understand if a company is understocking or overstocking its inventory.
5. Fixed Assets Turnover Ratio shows a company’s frequency of sales revenue generation using its fixed assets.
6. Days Payable Outstanding shows the average time in days taken by a company to repay its creditors.
E. Market Ratios
1. Price to Earnings Ratio shows the amount that investors must pay for each share they buy and the earnings attributed to per share bought.
2. Price to Book Value Ratio shows how the market value of publicly traded shares of a company compares with the book value of the same shares.