Essay on Financial Ratios

Introduction

Financial ratios provide a holistic picture of an organization’s financial health, and allow us to benchmark the organization’s performance against those of other organizations over time and over the relevant sector. This assignment will define the liquidity, leverage, management efficiency, and profitability ratio groups, as well as the respective financial ratios under each group. The following assignment was formulated with joint inputs from team members Crystal Mayfield, Crystal Kierum, Gunnar Wagner and Crystal Vining, of Group A2.

Liquidity Ratios

This group of ratios provides an analysis of whether the company has the capability of meeting its short-term financial liabilities, based on whether it can cash in its receivables and inventories to cover liabilities. Higher liquidity ratios demonstrate a stronger financial ability to pay the company’s current liabilities if they are due. Practical applications of liquidity ratios include the assessment of the firm’s solvency, qualification for loan applications at banks, and analysis of the firm’s liquidity position over time (Gibbons et al, 2015).

• Current Ratio = Current Assets / Current Liabilities
• Quick Ratio = (Current Assets – Inventory) / Current Liabilities

Leverage Ratios

This group of ratios tracks the degree of debt on a company’s balance sheet, with a higher debt to equity or debt to total asset ratio indicating a company that is higher in debt and potentially more risky. This is because higher debt levels in a firm indicate a higher breakeven point and a more volatile return on equity, and will show up in a higher ratio of debt to equity or assets, suggesting the company is largely financed by taking on additional debt than equity. This would differ across sectors, with capital expenditure heavy sectors such as manufacturing and pipeline infrastructure generally having higher leverage ratios due to the debt financing they would need to finance their capital expenditures (Gibbons et al, 2015).

• Debt to Equity = (Short-Term Debt + Long-Term Debt) / Total Shareholders’ Equity
• Debt to Total Assets = (Short-Term Debt + Long-Term Debt) / Total Assets
• Interest Coverage = EBIT Operating Profit / Interest Expense

Management Efficiency Ratios

This group of ratios demonstrates the extent that the firm is efficiency utilising its assets and stewarding its liabilities, with accounts receivable turnover showing the number of times a company makes in sales (turnover) as compared to its accounts receivable, and may be an indicator of an overly generous credit policy or debt collection issues. Similarly, days of sales outstanding and inventory measure how long a company can move its sales or turn inventory into cash (Gibbons et al, 2015).

• Accounts Receivable Turnover = Sales / Accounts Receivable
• Days Sales Outstanding = 365 / Accounts Receivable Turnover
• Days of Inventory = 365 / Inventory Turnover
• Accounts Payable Turnover = Costs of Goods Sold / Accounts Payable

Profitability Ratios

Finally, profitability ratios demonstrate whether a company can generate earnings relative to its costs, therefore evaluating the margin achieved by a business based on the efficiency of its material and labor utilisation, as well as its pricing strategy, cost structure and productivity. A higher profitability ratio indicates a more profitable business and strong growth prospects (Arditti, 1967).

• Gross Margin = (Sales – Cost of Goods Sold) / Sales
• Operating Margin = EBIT Operating Income / Sales
• Return on Assets = ( Net Income + [ Interest Expense * (1-T) ] ) / Total Assets
• Return on Equity = Net Income / Total Shareholders’ Equity

References

Arditti, F. D. (1967). Risk and the required return on equity. The Journal of Finance, 22(1), 19-36. https://www.jstor.org/stable/2977297

Besley, S., & Brigham, E. F. (2013). Principles of finance. Cengage Learning.

Gibbons, G., Hisrich, R. D., & DaSilve, C. M. (2015). Entrepreneurial finance: A global perspective. Thousand Oaks, CA: Sage.

Gitman, L. J., Juchau, R., & Flanagan, J. (2015). Principles of managerial finance. Pearson Higher Education AU.

Ruppert, D. (2014). Statistics and finance: An introduction. Springer.