In continuation of our series on “Accounting Basic for Startups”, this article will throw light on the calculation and interpretation of key financial ratios for evaluating the performance of a concern.
Why to calculate Financial Ratios? (Importance of Ratio Analysis)
Knowing how to calculate and use financial ratios is important for not only businesses, but for investors, lenders and more. Ratios allow you to compare a various aspect of a company’s financial statements against others in its industry, to determine a company’s ability to pay dividends, and more. In other words, analysis of ratios simplifies the comprehension of financial statements. The objective of preparing financial ratios can be understood from below:
- It provides data for inter – firm comparison. Makes inter-firm comparison possible.
- Helps to draw conclusions on performance, strengths & weaknesses of a firm and enables in decision making process.
- It highlights the factors associated with successful and unsuccessful firm. It helps to reveal the loopholes which are affecting the performance of the firm.
- It helps in planning and forecasting. Ratios can assist management, in its function of forecasting, planning, co-ordination and apply control techniques to manage financials.
How to derive Financial Ratios?
At the very outset, ratios are derived from the financial statements prepared by the enterprise. For effective understanding of values derived from these ratios, ratios are broadly classified into four categories:
i. LIQUIDITY RATIOS: “liquidity” or “short – term solvency”, measures the credibility of the concern to pay its short term liabilities. Traditionally, current ratio, quick ratio and operating cash flow ratio are used to highlight the business liquidity.
Current Ratio = Current Assets / Current Liabilities.
Quick Ratio = (Current Assets – Inventories) / Current Liabilities.
Operating Cash Flow Ratio = Operating Cash Flow / Total Debt
ii. LEVERAGE RATIOS: These includes the following ratios:
Debt – Equity Ratio = Total Liabilities / Shareholders’ Equity
It indicates the proportion of debt fund in relation to equity. A high ratio indicates less protection for creditors.
- Debt Service Coverage Ratio = Earnings available for debt service / (Interest + Installments)
“Earnings available for debt service” includes Net profit + Non-cash operating expenses + Non operating adjustments. It measures the firm’s ability to pay off current interest and installments.
- Interest Coverage Ratio = Earnings before interest and taxes / Interest
A high ratio implies the ability of the enterprise to meet its fixed liabilities, that is, interest obligations.
- Capital Gearing Ratio = (Preference Share Capital + Debentures + Long Term Loans) / (Equity Share Capital + Reserves & Surplus – Losses)
It indicates the proportion of fixed interest (dividend) bearing capital to funds belonging to equity shareholders.
Proprietary Ratio = Proprietary Fund / Total Assets
“Proprietary Fund” includes Equity Share Capital + Preference Share Capital + Reserves & Surplus – Fictitious Assets.
iii. ACTIVITY RATIOS: These ratios are employed to evaluate the performance of the firm in terms of management and utilization of assets. It includes the following ratios:
- Working Capital Turnover Ratio = Sales / Working Capital
Working Capital Turnover is further segregated into Inventory Turnover, Debtors Turnover and Creditor Turnover.
- Fixed Assets Turnover Ratio = Sales / Capital Assets
A high ratio indicates efficient utilization of fixed assets in generating revenue.
- Debtors Turnover Ratio = Credit Sales / Average Accounts Receivable
It throws light on the collection and credit policies of the firm and the rate at which the receivables are collected.
- Creditors Turnover Ratio = Credit Purchases / Average Accounts Payable
Like Debtors Turnover Ratio, it shows the velocity of debt payment by the firm.
iv. PROFITABILITY RATIOS: It measures operational efficiency of the firm based on assets/ investments, on sales, on capital market information or from owners, point of view.
- Gross Profit Ratio = Gross Profit / Sales X 100
It is used to compare product profitability.
- Operating Profit Ratio = Operating Profit / Sales X 100
It is calculated to evaluate the operating performance of business.
- Return on Equity (ROE) = Profit after taxes / Net Worth
It is one of the most important indicators of a firm’s profitability and potential growth. It reveals how profitably the owner’s funds have been utilized by the firm.
- Earnings per Share = Net profit available to equity holders / Number of Shares outstanding
It measures the profitability of a firm on the basis of value of each share in relation to retained profit of the firm.
- Price Earning Ratio = Market price per share / Earnings per share
It indicates the expectation of equity investors about the earnings of the firm. It relates earnings to market price and is used to measure the growth potential of an investment.
- Return on Investment (ROI) = Return / Capital Employed X 100
“Return” includes Net Profit +/- Non – trading adjustments + interest on long term debts + provision for tax – Interest / Dividend from non – trade investments.
“Capital Employed” includes total share capital + Reserves & Surplus + Long term loans – Miscellaneous expenditure and losses – Non trade Investments.
To Conclude – Financial Ratios helps to illustrate the strengths and weaknesses of a business and can also show any unusual fluctuations in financial trend of the business. Ratios are also helpful tools in financial analysis and forecasting; ratios allow entrepreneurs to set specific goals and to easily track progress toward those goals. But it is important to select ratios which are applicable to your business, as there are hundreds of financial ratios available, some of which apply to all businesses and some of which are industry-specific.
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