Financial ratios are calculations derived from an entity’s financial statements for purposes of assessing financial performance. Ratio analysis is the interpretation of these ratios to derive meaningful information for decision making. Financial ratios are divided into 5 categories which are liquidity, profitability, debt, activity, and market ratios (Gitman & Zutter, 2012). I will look at four ratios, each from a different category. I will discuss each ratio’s meaning and importance to investors and bankers.
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The quick ratio, also known as the acid test ratio (Swanstorm, n.d), belongs to the liquidity ratios category. It is arrived at by finding the ratio between an entity’s working capital and its current liabilities, with the working capital figure excluding inventory. It is a pessimist’s view of the solvency of a business in the short run, assuming that the business finds it difficult to sell its inventory (Young, 2012). It is used by banks to determine the ability of an entity to pay its loan installments (Swanstorm, n.d). Investors also use it to determine the ability of an entity to pay its creditors (Young, 2012).
The inventory turnover ratio belongs to the activity ratio category (Gitman & Zutter, 2012). It is arrived at by finding the ratio between the cost of inventory sold and the average inventory value. The ratio facilitates the determination of the liquidity of an entity’s inventory. A bank would require this ratio in order to determine if the entity’s inventory is liquid enough to provide free cash to pay up loan installments. An investor would also require this ratio to determine how fast the entity sells its inventory.
The debt ratio is in the financial leverage ratios category. It is calculated by finding the ratio between the entity’s total debts and its total value of assets. The ratio facilitates the determination of the proportion of the investors’ assets that are financed by borrowed capital (Gitman & Zutter, 2012). A high debt ratio may indicate a risk of insolvency. Banks use this ratio to determine whether a firm has borrowed too much to the level of risking insolvency. Investors also use the ratio to determine the risk associated with debt that they would assume by investing in the entity (Young, 2012).
Operating profit margin is a ratio in the profitability ratios category (Gitman & Zutter, 2012). It is arrived at by finding the ratio between the income from operations and the turnover. This ratio is useful in determining the efficiency of a business in generating revenue. Bankers use this ratio to determine the proportion of sales available for paying interest on loans. Investors also use this ratio to determine the amount available to pay up debt and dividends.
Gitman, L. J., & Zutter, C. J. (2012). Managerial Finance, 13th ed. Upper Saddle River, New Jersey: Prentice Hall.
Swanstorm, W. (n.d). The Importance of Financial Ratios. Web.
Young, R. C. (2012). Financial Ratios Used by Investors. Web.