Financial ratios are mathematical values obtained by comparing two numerical figures from the financial statements of a company that are used to evaluate the performance of the company. Examples of three key ratios that are commonly used to evaluate the financial performance of a company include liquidity ratios such as current ratio and quick ratio, profitability ratios such as profit margin and return on investment (ROI) and activity ratios such as inventory turnover and account receivables turnover.
Firstly, liquidity ratios measure the ability of a firm to meet its current obligations. Liquidity ratios show the ability of a firm to convert its current assets into cash, thus enabling it to pay current liabilities. A firm should have a current ratio of 2. If the current ratio of a firm is below 2, then the company may not be able to convert its current assets into cash in order to pay its obligations that are due. Liquidity ratios affect the types and quantity of current assets held by the company, for example, a low liquidity ratio would compel the firm to hold more stock. For an analyst, firms with higher liquidity ratios offer secure investment portfolios.
Secondly, profitability ratios measure the ability of a firm to generate adequate profits or returns from trading activities. For example, the profit margin ratio is used to evaluate the amount of gross and net profits earned from trading activities. Additionally, the return on investment (ROI) ratio is used to evaluate the ability of a firm to use capital investment or long-term assets efficiently in generating additional value to shareholders’ equity. High profitability ratios are preferred because they indicate that a firm is able to adequately deploy its investments in generating profits or returns. On the other hand, lower profitability ratios indicate that a firm is not able to generate adequate returns from its investments and business activities thus might be operating at a loss. Profitability ratios of a firm will influence the investment decisions by an analyst.
Thirdly, activity ratios are used to measure the ability of a firm to convert its current assets such as stocks into cash. Activity ratios show how long it takes a firm to convert current assets into cash. For example, inventory turnover ratio shows the number of days it takes a firm to sell its stock whereas account receivables turnover indicates how long it would takes a firm to collect debts from the debtors. In my opinion, higher activity ratios are preferred because they indicate that a firm can easily convert the current assets into cash. This increases the ability of the firm to conduct business more efficiently. It also increases the ability of a firm to meet its current obligations that are due. Firms with high activity ratios are more profitable and suitable for investment.
Financial Analysis and Decision-Making Processes
In my opinion, financial analysis may obtain information that is proactive to decision making through exhaustive examination and comparison of financial ratios of a financial period with previous financial periods of the firm. Moreover, the financial ratios obtained for any given firm must be compared with financial ratios of other firms in the same industry in order to evaluate the financial performance of the company. Comparisons across the industry enable determination of financial performance of a firm against other firms hence provide more reliable information that is useful for decision-making processes. Moreover, financial ratios should also be calculated from accurate and reliable financial statements in order to improve their credibility and authenticity.