Managerial Finance and Its Principles Essay

Introduction

Company financial statements are vital for analyzing company’s position in the industry in terms of finances. Financial ratios analysis is part of the financial statements. Businesses use financial ratios gauge or give a measure of their economic performance and financial position at a time. They also help the firm to analyze its growth trend and make comparisons with other businesses in the industry. The categories of the financial ratios are based on the type of information they convey. Main categories are profitability, liquidity, efficiency and leverage ratios.

Profitability Ratios

The profitability ratios are intended to assess the business’s capacity to earn. The data used to compute these ratios is drawn from profit and loss statements. Profit and loss analyses are essential for stockholders since they gauge business’ success.

1. Gross Profit Ratio (GPR) = Gross Profit/Sales (Gitman, 2009, p.62).
2. Net Profit Ratio (NPR) = Net Profit/Sales (Gitman, 2009, p.64).
3. Return on Owners’ Equity Ratio (ROE) = Net Profit/Owners’ Equity.

A firm always seeks to have highest GPR and NPR possible. An NPR of 1 or less indicates a poor performance (losses). ROE shows the returns the shareholders get from investment and this indicates the efficiency of the venture (Gitman, 2009, p.65).

Liquidity Ratios

Liquidity ratios generally describe capacity of the business to access money for its daily operations (Gitman, 2009, p.54). Consequently, the ratios under this category evaluate the firm’s ability to pay all its debtors when they are due.

• Current ratio = Current Assess/Current Liabilities (Gitman, 2009, p.54)
  • A current ratio of 2:1 indicates the firm is thriving business and that its assets can pay back the firm’s debts. A 1:1 ratio means the assets value is equal liabilities value.
• Quick (Acid) Ratio = (Cash + Accounts Receivable)/Current Liabilities
  • The ratio describes the assets convertible into quick cash over current liabilities. This ratio leaves out inventory as it does not assure cash (Gitman, 2009, p.55).

Efficiency

The ratios under this category are used to manage firm’s resources and they show whether the firm is efficient or not in its asset management to meet its goals.

1. Expense Ratio = Expenses/Sales.
2. Inventory turnover = Cost of Goods Sold/Ave. Inventory (Gitman, 2009, p.56).

This turnover ratio analyzes the amount of stock the firm sells during the year.

Leverage

Ratios under this category make comparisons between the finances of the business owners against the creditors’ contribution. The ratios measure the firm’s ability to meet its duties against it debt capacity;

• Debts to Assets (Debt Ratio) = Total Liabilities/Total Assets (Gitman, 2009, p.60).
  • This ratio expresses the degree to which the firm’s assets are funded by the business creditors. A lower ratio shows a business is well cushioned against losses.
• Debt Coverage = Net profit + Depreciation /Current Maturities Long-Term Debt
  • This ratio is a measure of the degree to which the company’s income plus non-cash expenses can drop without impinging on its ability to pay the long-term debts. Leased assets and the firm’s debt under lease contract are deliberately excluded.

Pros and Cons

Pros

1. The ratios are convenient for presenting the firm’s current financial performance in relation to previous years.
2. The ratios can be used to represent the short- and long-term stability of the business’s monetary position.
3. The ratios help to identify the firm’s financial strengths and weaknesses.
4. The ratios offer companies some important economic benchmarks to work with.
5. The ratios are simple since they only require information from financial statements.

Cons

1. The ratios are not reliable in making future predictions about a firm’s future financial position as they are mostly retrospective.
2. The ratios cannot show the state of the business operation and legal situation since they are only based on accounting data and not legal and economic facts
3. The ratios can be manipulated by accounting alterations to fit a certain outcome.
4. The ratios cannot analyze features like morale and inspiration by the staff of the firm.

Conclusion

A firm’s financial statements offer quantitative insights on its performance. Though all the numbers in the statements are important, they do not show a comprehensive assessment of the firm’s overall performance. Thus, the financial ratios offer a detailed analysis of the firm’s performance.

Reference

Gitman, J., (2009). Principles of Managerial Finance. (12^th Ed.). Boston, MA: Pearson Prentice Hall.