Financial Ratios Analysis For Your Business
Financial ratios analysis are normally used by current and potential investors, creditors and financial institutions to evaluate a company’s past performance and identify trends in a business and compare its performance along with the average industry performance. It also enables them to identify strengths and weaknesses of an business and to justify further investments in the business.
Categories of ratios:
There are five broad ratio categories which are in use for the purpose of measuring the different aspects of risk and return relationships.
1. Liquidity analysis
2. Solvency analysis
3. Profitability analysis
4. Performance analysis.
The credit analyst’s main focus is the relationship shown by the ratios and in case of any disaggregation, it should be done by taking the different variables which are relevant to either of the basic indicators in the ratio.
1. Current Ratio Formula = Current assets/current liabilities
2. Quick or Acid text ratio Formula = Current assets less stock/current liabilities
This is the ratio or comparison between the current liabilities and current assets of a firm. Current assets comprises of the following:
cash balance, bank balance, sundry debtors, inventory, advance paid to suppliers etc. Similarly, current liabilities comprises of the following bank overdrafts, sundry creditors, provisions for tax and others, advance payment received from the customers etc.
The formula for arriving the ratio is current assets/current liabilities.
This ratio offers an approximate measure of the company’s ability to pay its current maturing obligations on time. Generally, higher the ratio, the greater the cushion a company has to work within meeting its current obligations. It is normally believed that current ratio of 2 to 1(current asset:2 and current liabilities:1) is viewed as a sign that a company had done well. However, it is at present recognized that other factors such as the composition and quality of assets should be considered.
The ratio measures the short term solvency of the company, it shows the present position of the firm and its ability to meet its current obligations. The higher the ratio the better the position of a firm to meet its daily obligation, however high current ratios affects the firms profitability in the long run as more of assets are held in liquid form rather than in long term investment.
The current ratio doesn’t provide the credit analysts with the quality of assets or timing of the liabilities. From the ratio, the period in which the sundry debtor is expected to be paid; or the sundry creditor is expected to be paid etc., cannot be calculated. It just gives a comparative financial ratios analysis of the current asset and current liabilities.
Internally, managers use these ratios to monitor performance and set specific goals, targets, and policy initiatives. Externally, these ratios can be a clear indication of the financial health of the business for investors.
