Financial ratios can be viewed as indicators of various financial aspects of an organisation. Liquidity ratio can be related to the short-term liability handling capability of a company and profitability ratios can be understood as an index to measure profit making capability at various levels of inspection. Liquidity and Profitability are important aspects which must be measured for a business, but there are other financial attributes which are important to check solvency, efficiency, and market value of a company to efficiently manage a company and to make investment related decisions in the company.
Solvency Ratios
As the name suggests solvency ratios are used to estimate solvency of a company. The word solvency in financial context means the capability of a company to maintain long-term operations and meet long-term obligations towards creditors and shareholders. Mathematically solvency ratios can be understood as the ratios used to compare forces of money generation and money consumption which are commonly known as profitability and financial obligations. The general relation for solvency ratio can be summarised as:
Solvency Ratio = (Net Income + Depreciation) / All Liabilities (Short-term + Long-term Liabilities)
a. Debt to Equity Ratio:
Formula: Debt to equity ratio = Total Liabilities / Shareholder’s Equity
Significance: Debt to equity ratio in simple words is a measure of financial leverage of a company which actually quantifies the degree to which a company is using debt to fund operations. The mathematical value can be obtained by dividing total debt by total shareholder’s equity. A lower value of this ratio is preferred as a lower value indicates that company is using debt to a lesser degree to run its operations.
b. Interest Coverage Ratio:
Formula: Interest coverage ratio = Earnings Before Interest and Taxes (EBIT) / Interest Expenses
Significance: This ratio in layman terms can be described as a company’s capability to cover interest on debts by profits from day-to-day operations. Mathematically it is obtained by dividing the earnings before taxes by interest expenses. A higher value will indicate sufficient operating profits to pay for interests on debt hence greater sustainability.
Efficiency Ratios
Efficiency ratios in simple words are ratios which indicates the efficiency of a company to generate profits using resources, capital, and assets. These ratios are basically for comparing the expenses with the profit generated for business operations.
a. Inventory Turnover Ratio:
Formula: Inventory turnover ratio = Cost of Goods Sold / Average Inventory
Significance: As the name suggests this ratio computes the number of times a company sells out the stock it has in a particular time frame. The higher this ratio is greater number of times it sells out its stock hence greater is the profit as average inventory for that time is less.
b. Accounts Receivable Turnover Ratio:
Formula: Accounts receivable ratio = Net Credit Sales / Average Accounts Receivable
Significance: This ratio in simple words is actually the number of times an organisation collects its accounts receivables over a particular period of time. This ratio in simple words calculates the efficiency of revenue collection for a given time period. It is calculated by dividing net credit sales by average accounts receivables where net credit sales is sales on credit minus sales returns and sales allowances and average accounts receivables is the average of starting and ending accounts receivables balance.
c. Asset Turnover Ratio:
Formula: Asset turnover ratio = Revenue / Average Total Assets
Significance: In simple words it is the measure of how sales in pound every pound invested in assets is generating. It is calculated mathematically by dividing net sales which is sales allowance, sales returned, and sales discounts subtracted from total sales by average total assets.
d. Accounts Payable Turnover Ratio
Formula: Accounts Payable Turnover ratio = Net Credit Purchase/ Average Accounts Payable
Significance: Accounts payable turnover ratio is a number which is actually average number of times a company pays its creditors in a particular period. This ratio is also an indicator of short-term liquidity as higher value of the accounts payable ratio means that the company is able to hold the cash for longer time. This is also correlated to the working capital funding gap inversely.
Market Value Ratios
Market value is simply the worth of a company or an asset in the financial market. Market value ratios are ratios which help in getting information about performance of a company in the market and the perceived value by the investors for the company.
a. Price to Earnings (P/E) Ratio:
Formula: Price to Earnings ratio = Market Price per Share / Earnings per Share (EPS)
Significance: This ratio is simply market price share of a company divided by the earnings per share which indicates the amount of investment an investor would be willing to invest per round of earning. A higher price to earning ratio will indicate higher odds for future as investors would be willing to invest more in the company.
b. Dividend Yield:
Formula: Dividend yield = Annual Dividends per Share / Market Price per Share
Significance: Dividend yield in layman terms gives the return on investment for shareholders. It is ratio of annual dividends per share to marker price per share which is an indicator of the company’s ability to efficiently make profit for the shareholders. A high value of dividend yield can attract investors who are income focused.
Conclusion
Profitability, sustainability and efficiency of any business depends the efficient decision making and financial planning in every aspect of business. Analysis of financial ratios helps in getting insights about various aspects of a business-like liquidity, profitability, solvency, market performance, and efficiency. Periodic review of these ratios helps business owners in process improvement strategies, identifying weakness and strengths, and adjusting plan of actions in accordance with the future goals of the business. Business owners in the United Kingdom can learn the fundamentals of these ratios and can implement these concepts to monitor, review and adjust their strategies to ensure growth and profitability of their business.
