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Ratio analysis is of great importance when it comes to the assessment of the financial position and health of any business enterprise. It may be a tedious activity but once results have been obtained from the computation, interpretation is fast and easy.
Ratios can therefore be used by potential investors, creditors, and money lending institutions such as banks as well as the company management to judge how the company is progressing (Jan et al, 2008, p. 266).
Ratios work by comparing two or more items on any of the prepared financial statements of a company such as the balance sheet, income statement, cash flow statement and many others (McManus, 2009, p.1). Ratios are grouped into different classes depending on their final use.
These classes include: liquidity ratios which give an indication of whether the company is able to meet its liabilities in the short run. Profitability ratios are used to determine whether the enterprise has the ability to handle its expenses and make profit in return to the resources it has put into the enterprise (Houston and Brigham, 2009, p. 90).
The list of the type of ratios that can be calculated from any financial statement is endless since almost all items on these financial statements have some degree of correlation. The information obtained from financial ratios analysis, other than giving an impression of how the company is fairing on, it can be used by external bodies to determine the credit worthiness of the company
A common example of a liquidity ratio is the current ratio which compares the liquid assets of a company to the non-fixed or current liabilities. It is therefore calculated as follows:
Current ratio = Current assets/ Current liabilities
This ratio is very important as it shows the company’s potential to pay for its short term liabilities. Any creditor to the company will have to look at this ratio so as to depict the credit worthiness of the company in the short-term which will depict its ability to pay the long-term as well.
The second ratio is the Return on capital employed (ROCE) which is a profitability ratio. This ratio as the name suggests shows the correlation between the operating profits that has been generated during a certain trading period from the average long-term capital that has been invested in the company. In other words it shows what the company has managed to reap from the resources that it has invested for a certain period of time. It is calculated as follows:
ROCE= Net profit prior taxation and interest x 100
Share capital + long-term loans+ Reserves
This ratio is of great significance to the investors as they are able to predict how their investments are bound to fair in the targeted company.
Another common profitability ratio is the Gross profit margin which depicts the relationship of the sales of the company and the generated gross profit. It is therefore calculated as: Gross profit x 100
This ratio shows how profitable the company is and is therefore used by money lending institutions such as banks as well as investors before making the decision of entering into financial transactions with the company (Jan et al, 2008, p. 266).
Last but not least is an example of efficiency ratios that show how the company makes use of the resources it has. This is the Average inventories turnover period calculated as: Average inventories held x 365
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Cost of sales
This ratio is used to determine the average number of days that the company is holding inventories. Again the investors and banking institutions use this ratio as a gauge of the company’s progress.
From the aforementioned examples of ratios, it can be deduced that ratio analysis is an important process of the business enterprise as it provides information to external users such as banks, creditors and investors in addition to assisting in the management of the enterprise or company (McManus, 2009, p.1).
Houston, F. And Brigham, E. (2009). Fundamentals of Financial Management. [Cincinnati, Ohio]: South-Western College Pub.
Jan, W. Haka, S. Bettner, M. And Carcello, J. (2008). Financial & Managerial Accounting. McGraw-Hill Irwin.
McManus, G. (2009). Financial ratio analysis. Retrieved from https://www.bizmove.com/finance/m3b3.htm