Significance of Financial Ratios in Evaluating the Financial Performance of a Company

Quality and Price RatioFinancial ratios are considered to be the best tool for evaluating the financial performance of a company. Different financial ratios highlight different aspects of the financial performance of a company. Following is a brief introduction to the ratios that are used in ratio analysis.

Profitability Ratios

Stakeholders of the company are interested in the profitability of the company because the dividend payout depends upon the profit of the company. Therefore, in order to decide whether to continue the investment in a company the stakeholders of the company consider whether they are being benefited by the company.

Gross Profit Margin

Formula:

Gross Profit Margin = Gross Profit/ Total Revenue

Gross profit margin helps the users of the financial statements assess the ability of the company to maintain an efficient difference between the total revenue and the production cost. This ratio indicates whether the company maintains a healthy margin over the sale of its products or services, and whether the cost of production of the company is reasonably low or unacceptably high.

Operating Profit Margin

Operating Profit Margin = Operating Profit/ Total Revenue

Operating profit margin allows the users of the financial statements to determine whether the company has control over its operating costs. This ratio interests the stakeholders and prospective investors more because it indicates a great deal about the profitability of the company.

Return on Capital Employed (ROCE)

Return on Capital Employed = Net Profit/ Total Assets

Return on capital employed is considered to be one of the most important ratios because it indicates whether the company has made efficient use of its resources.

Efficiency Ratios

Efficiency ratios indicate whether a company uses its assets and liabilities efficiently. These ratios help the users of the financial statements identify the efficiency of the company in repaying its liabilities and recovering its financial assets. Following are some of the efficiency ratios.

Sales to Capital Employed

Sales to Capital Employed = Total Sales / Total Capital

This is an important efficiency ratio because it indicates the amount of sales being generated against the total resources available to the company. This ratio primarily indicates the efficiency of the company in utilizing the available resources.

Sales to Fixed Assets

This ratio indicates the fixed asset capacity of a company. With the help of sales to fixed assets ratio, users of the financial statement can infer whether the company is performing optimally, at overcapacity, or inefficiently.

Stock Turnover

Stock Turnover = Cost of Sales / Average Stock Value

This ratio represents the efficiency of a company with regard to management of the inventory. If the stock turnover of the company is low, this may indicate that the company is does not manage its inventory efficiently and there may be slow moving inventory.

Debtor Days Ratio

Debtor Days Ratio = (Trade Debtors / Sales) x 365

This ratio indicates whether the company has maintained an effective system of recoverability of trade receivables. This ratio also represents the policies of the company regarding credit sales.

Creditor Days Ratio

Creditor Days Ratio = (Total creditors / (Cost of sales + purchases)) x 365

This ratio indicates whether a company pays its trade creditor within a feasible span of time. If this ratio is too high, it might indicate the inability of the company to deal with its short term liabilities.

Liquidity Ratios

Liquidity ratios represent the ability of a company to deal with its short term liabilities. These ratios hold significant importance because they indicate whether the company is capable of running its day to day operations without requiring any further financing.

Current Ratio

Current Ratio = Current Assets / Current Liabilities

This ratio measures whether the company is able to pay its debts that are due within the period of one year from its current assets i.e. the assets that can be turned into liquid cash in a reasonably short period of time.

Quick Ratio or Acid Test Ratio

Quick Ratio = Cash and near cash / Current Liabilities

This ratio further refines the current ratio by eliminating all the current assets that cannot be transformed into liquid cash in a relatively short period of time. This ratio indicates the company’s ability to deal with its short term liabilities in a very short period of time.

Stability Ratios
Stability ratios are particularly important for the stakeholders of the company who seek to have long term investments. These ratios indicate whether the finance structure of the company is such that the company will be able to continue its operations in the long term.

Gearing

Gearing = Total borrowing / Shareholders’ Funds

This ratio represents the finance structure of the company. Users of the financial statements can determine whether the company relies upon the debt financing or upon the shareholders’ equity in order to run its operations.

Interest Cover

Interest Cover = Operating profit before interest / Interest

This ratio represents the ability of a company to pay the finance costs of its debts. This ratio is considered to be important by the users of the financial statements, specifically by the creditors of the company. The creditors need to ensure that the company will be able to pay the interest on the debt along with the instalments of debt repayment.

Investor Ratios

These ratios have been classified into a set to assist the investors in deciding whether to invest in the company. Following are some of the investor specific ratios.

Earnings per Share (EPS)

Earnings per Share = (Net profit after tax – Preference dividend) / No. of common shares

This is a highly important ratio for long term investors as this directly represents the returns generated by the company over each share. This ratio indicates the ability of a company to pay out dividends.

Price-Earnings Ratio

Price-Earnings Ratio = Market price of share / Earnings per share

This ratio interests short term investors who seek to benefit from the change in market value of the stock of the company. This ratio is normally compared to the industry average in order to determine whether the company has a good P/E ratio.

Dividend Yield

Dividend Yield = (Dividend per ordinary share / Current market price of share) x 100

This ratio indicates the extent to which the company pays dividends from its distributable profits. Dividend yield is also used to assess the extent to which the company holds back its earnings as reserves. This ratio is highly important for the investors as it indicates whether the company maintains a good payout ratio.

Thus, it can be concluded that financial ratios hold very high significance in highlighting the financial performance of a company. Each ratio explores a different aspect of the financial performance of the company and collectively all the ratios present a complete picture of the financial health in a very plausible manner.

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