A financial ratio refers to the relationship that shows the performance of a firm’s activities. Various ratios are used in the financial analysis to examine the current performance of the company as well as comparing the past with the present.
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This is very important in the sense that it helps in identifying problems which need to be fixed. Besides, ratio analysis helps management to pay particular attention to those problems that pose a lot of danger to the company’s performance and to reach at strategic decision to avoid such potential problems.
Moreover, the management of the company can use financial ratios for comparison purposes, that is, comparing the firm’s performance against that of the competitors, as well as the entire industry (Jan, Haka, Bettner and Carcello 265).
The main aim of calculating financial ratios is to analyze and show broad business trends, which are very crucial in sound decision making processes. Therefore, accuracy in ratio calculation and analysis is important because they help in avoiding errors, financial misrepresentation, and false findings that lead to inaccurate decisions.
Types of Financial Ratios used in Managerial Decision making
Some of the ratios that can be used in this analysis to make managerial decisions include, but not limited to current ratio, liquidity ratio, stock financing ratio, and solvency ratio (Kane, Zane and Marcus 458). Broad analysis of these financial ratios and their use in making managerial decisions are presented in the following discussion.
This is calculated as follows:
Current ratio = Current Assets/Current Liabilities
Current ratio shows the situation of the company’s working capital, that is, it reflects the firm’s ability to settle payments for the short term creditors using the proceeds realized from the company’s current assets without necessarily selling the fixed assets to settle the credit payments (Houston and Brigham 89).
A figure that is greater than 1 informs the management that there are sufficient assets to settle the company’s liabilities once there is some urgent need. However, the management should be very cautious in cases whereby the figure is less than 1, and in such a situation managerial decisions should be made promptly to acquire more current assets.
The formula for calculating is shown below.
Liquidity ratio = (Current Assets – Stock)/Current Liabilities
This ratio shows that the company is capable of paying debts as soon as they are due for payment. This can be regarded as the most accurate measure of a firm’s financial health that managers can rely on when making crucial decisions because the ratio excludes the element of stock thus it reduces risks associated with redundant and slow moving stocks (Houston and Brigham 89).
In comparison to the current ratio, the figures of the liquidity ratio are much lower. For example, supermarkets can survive with liquidity ratios that are as low as 40% or 0.4 because goods are actually received and solved before payments are settled on them.
But, the management should recommend for a figure that is higher than 1 in order to have sufficient cash for settling credit payments. However, a figure that is extremely low would prompt the management to review financial health of the business.
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Some of the key managerial decisions that the company’s management team can undertake is to reduce the level of stock so as to realize a higher liquidity ratio. Non-performing and redundant stocks can be transferred to other fast moving branches of the company.
In sum, financial ratios such current ratios and liquidity ratios, among others are very crucial in managerial decision making. Therefore, managers should base their decision on the calculated ratios. However, it is important to show ratios that are accurately calculated so as to avoid errors in decision making.
Houston, Joel and Brigham, Eugene. Fundamental of Financial Management. Cincinnati, Ohio: South Western College Publication, 2009. Print.
Jan, Williams, Haka, Susan, Bettner, Mark and Carcello, Joseph. Financial and Managerial Accounting. New York, NY: McGraw-Hill Irwin, 2008.Print.
Kane, Alex, Zane, Bodie and Marcus, Alan. Essentials of Investments. New York, NY: McGraw-Hill Irwin, 2004. Print.