Financial Ratios
Financial ratios are vital tools for assessing a company’s financial health and performance which guide us to make sound investment decisions. These ratios provide valuable insights into a company’s profitability, liquidity, efficiency, and solvency, enabling investors to make informed decisions.
Ratios allow stakeholders to gauge a company’s strengths, weaknesses, and overall financial stability. In this article, we will delve into some of the most important financial ratios and explore how they can guide strategic decision-making.
Liquidity Ratios
Liquidity ratios assess a company’s ability to meet short-term obligations and its overall liquidity position. The two most widely used liquidity ratios are the current ratio and the quick ratio.
The current ratio is calculated by dividing current assets by current liabilities, indicating a company’s ability to pay off its short-term debts.
It is also important to note that the current ratio has a few limitations. Some limitations are that the ratio expresses the quantity of current assets but not the quality. Additionally, the current ratio could appear higher if current assets were overvalued.
The quick ratio, also known as the acid-test ratio, is a more stringent measure that excludes inventory from current assets. This gives investors a good picture of assets that can be easily converted into cash to pay off current liabilities.
If a company has a quick ratio of 1.5, it will mean that for every $1 of current liabilities, the company has liquid assets worth $1.50 to cover the liability.
Profitability Ratios
Profitability ratios measure a company’s ability to generate profits from its operations. Key profitability ratios include the gross profit margin, operating profit margin, and net profit margin.
Gross Profit Margin: The gross profit margin reveals the percentage of revenue remaining after deducting the cost of goods sold.
To give an example, let’s assume we run a company that sells phones, and we make $1,000,000 in revenue and it costs me $600,000 to produce the phones. My gross profit margin would be [(1,000,000 – 600,000)/1,000,000] = 40%. This translates to my company retaining $0.40 for every $1 in revenue generated after accounting for the direct costs of producing goods.
Operating Profit Margin: The operating profit margin reflects the profitability of a company’s core operations by considering operating expenses.
Running a company that sells phones would involve other expenses as well such as salaries, utilities, and rent. If these expenses cost $300,000, my operating profit margin will be [(1,000,000 – 600,000 – 300,000)/1,000,000] = 10%. This would mean that for every $1 of revenue, my company retains $0.10 after deducting direct costs and operating expenses.
Net Profit Margin: Lastly, the net profit margin shows the percentage of revenue that remains as net income after all expenses, including taxes and interest.
Using the above example, let’s assume now that my company incurs $50,000 in taxes. Subtracting this sum from the above example, [(1,000,000 – 600,000 – 300,000 – 50,000)/1,000,000] = 5%. So, for every $1 of revenue, I retain $0.05 as net profit after considering the above factors.
Conclusion:
Financial ratios serve as invaluable tools for analysing a company’s financial performance and making informed decisions. These ratios allow stakeholders to assess a company’s liquidity, profitability, efficiency, and solvency, providing a comprehensive view of its financial health. It is essential to consider these ratios in conjunction with other factors, industry benchmarks, and trends to gain a complete understanding of a company’s financial position. Understanding and utilizing financial ratios empower stakeholders to navigate the complex world of finance with confidence.
In this article, we touched on liquidity and profitability ratios only. Stick around for our next article where we will discuss more on efficiency and solvency ratios.
Disclaimer: The information presented is not intended to be financial advice and readers should seek professional advice before making any financial decisions. The author and publisher are not responsible for any losses or damages that may result from the use of the information presented in the article.