Financial Ratios

The Financial Ratios are compared with those of the competition and lead to the analysis and reflection of the operation of the companies against their rivals. These give indicators to know if the evaluated entity is solvent, productive, if it has liquidity.

Summary

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  • 1 Definition
  • 2 Importance
  • 3 Classification of financial ratios
    • 1 Liquidity ratios
    • 2 Current or circulating ratio
    • 3 Quick reason
    • 4 Reason for availability
    • 5 Reasons for activity
    • 6 Rotation of total assets
    • 7 Rotation and inventory cycle
    • 8 Industrial Companies
    • 9 Rotation and cycle of accounts receivable
    • 10 Debt reasons
    • 11 Debt or debt ratio
    • 12 Debt / equity ratio
    • 13 Autonomy or self-financing
    • 14 Profitability reasons
    • 15 Gross profit margin
    • 16 From operating expenses incurred
    • 17 Financial Return
    • 18 Profit on total assets or Economic Return
    • 19 Variation in sales
    • 20 Variation in Net Income
  • 4 Source

Definition

  • They are a photograph of the moment, avoiding the dimension in time.
  • They constitute a second level of diagnosis.
  • They make it possible to provide an overview of the economic-financial situation as a whole.
  • They are the starting point of the analysis.
  • They are consequences of policies and events and not of causes.
  • The use of numerous reasons can be confusing, rather than clarifying the nature of the problem.
  • They cannot be more exact than the information that your calculation allows you.

Importance

The financial ratios are of significant importance for any company, because their calculations and interpretation of the results allow the entity to know its performance, position, background and financial trends, serving as the basis for its future projection, from which it is derived the utility that it represents for the financial manager, because it allows him to know if the business is developing in a favorable or unfavorable trend and therefore it is necessary to have a basis for comparison rule, since a reason becomes significant when compared to a standard. From the above it follows that the financial indexes serve as guidelines so that the financial administrator together with the directive cadres,

Classification of financial ratios

  • Liquidity reasons.
  • Activity reasons.
  • Debt reasons.
  • Profitability Reasons.
  • Growth reasons

Liquidity ratios

Its main objective is to determine the financial conditions in which the entity is in order to face the payments that derive from its operating cycle. When applying for a loan, the company will need to demonstrate that it is in a position to face its debt, this is the reason why credit analysts analyze various liquidity measures. Managers look at liquid assets, which are the ones that can easily be converted into cash at fair market value, as they represent these more reliable figures, although they have the inconvenience that they can quickly lose validity. Liquidity is an ability to meet short-term obligations when they mature, it will be given by the liquid asset that is available, which is one that can easily be converted into cash at fair market value. Liquidity is the ability of a company to pay its short-term obligations when they are due. Liquidity is essential to direct a business activity, particularly in times of adversity, such as when a business closes due to a strike or when losses in operations occur due to an economic recession or a considerable increase in the price of a raw material. or from a piece of equipment; If liquidity is insufficient to cushion such losses, a serious financial difficulty can arise. Poor liquidity resembles a person with a fever a symptom of a fundamental problem. Liquidity is the ability of a company to pay its short-term obligations when they are due. Liquidity is essential to direct a business activity, particularly in times of adversity, such as when a business closes due to a strike or when losses in operations occur due to an economic recession or a considerable increase in the price of a raw material. or from a piece of equipment; If liquidity is insufficient to cushion such losses, a serious financial difficulty can arise. Poor liquidity resembles a person with a fever a symptom of a fundamental problem. Liquidity is the ability of a company to pay its short-term obligations when they are due. Liquidity is essential to direct a business activity, particularly in times of adversity, such as when a business is closed due to a strike or when losses occur in operations due to an economic recession or a considerable increase in the price of a raw material. or from a piece of equipment; If liquidity is insufficient to cushion such losses, a serious financial difficulty can arise. Poor liquidity resembles a person with a fever a symptom of a fundamental problem. as occurs when a business is closed due to a strike or when losses in operations occur due to an economic recession or a considerable increase in the price of a raw material or piece of equipment; If liquidity is insufficient to cushion such losses, a serious financial difficulty can arise. Poor liquidity resembles a person with a fever a symptom of a fundamental problem. as occurs when a business is closed due to a strike or when losses in operations occur due to an economic recession or a considerable increase in the price of a raw material or piece of equipment; If liquidity is insufficient to cushion such losses, a serious financial difficulty can arise. Poor liquidity resembles a person with a fever a symptom of a fundamental problem.

The analysis of the liquidity of a company is especially important for creditors. If a company has a poor liquidity position, it can create credit risk, perhaps leading to an inability to make significant and periodic interest payments. Liquidity ratios are static in nature at the end of the year. Therefore, it is also important for management to examine future cash flows, if high cash disbursements are expected in the future relative to income, the company’s liquidity position will deteriorate.

Current or circulating ratio

The current ratio is equal to the current asset divided by the current liability. This relationship, which is subject to seasonal fluctuations, is used to measure the ability of a company to settle its current liabilities with current assets; requires a high reason when the firm has difficulty obtaining short-term loans. A limitation of this reason is that it can rise just before financial difficulties, due to a company’s desire to improve its cash position, for example, through the sale of fixed assets. Such provisions have a detrimental effect on productive capacity. Another limitation of the current ratio is that it will be excessively high when inventory is carried out based on the last to enter and the first to leave.

It shows the ability of the company to meet its short-term obligations with its current assets. It measures the number of times that the business’s current assets cover its short-term liabilities. For its analysis, the quality and character of current assets must be taken into account in terms of their ease of becoming effective and the maturity dates of short-term debts. This type of reason gives a rough view of the company’s ability to meet its short-term commitments. It is probably the first test developed by analysts and it is placed by them in the most important place. The analysis of this ratio shows the amount of current assets that the company has to face each peso of its short-term obligations.

  • When interpreting the current ratio, it is necessary to take into account a number of factors:
  1. Creditors tend to believe that the higher the current ratio, the better, although from a managerial point of view there is an upper limit. A too high current ratio may indicate that capital is not being used productively in the company.
  2. Because creditors tend to view current ratio as an indication of short-term solvency, some companies may take deliberate steps to improve their current ratio just prior to the presentation of the financial statements at the end of the fiscal period in order to present it to bankers and other creditors. This can be accomplished by delaying credit purchases and paying current liabilities.
  3. The current ratio calculated at the end of the fiscal year may not represent the current position of the company throughout the year. Since many of them schedule the end of the fiscal year during a low point in the commercial season, the current ratio at the end of the year is probably more favorable than in any other period of the year.

Quick reason

The quick ratio, also known as the acid test ratio , is a rigorous liquidity test. It is found by dividing the most liquid current assets (cash, marketable securities and bills, accounts receivable) by current liabilities. Inventory is not included because it takes longer to convert to cash. Prepaid expenses or other payments are also not included because they are not convertible into cash and therefore cannot cover current liabilities.

It is a more rigorous test of liquidity since it indicates immediate solvency, without considering inventories, as these generally turn out to be the least liquid and constitute a strict test of the ability to pay in the short term. It is also known by the name of fast reason .

It shows the ability of the company to meet its short-term obligations with its most liquid assets, must be greater than 1. This ratio assumes the immediate conversion of the most liquid current assets into money to pay off the most pressing or urgent obligations. An index of 1 is considered acceptable, since it indicates that the necessary resources are available with a certain speed to cover each peso of the immediate debts.

Availability reason

  • Cash on hand + Cash on Bank / Current liabilities
  1. The desirable mean value should be approximately 0.3.
  2. If it is less, the entity has no minimum capacity to meet its short-term obligations.
  3. If it is greater, the entity has the minimum capacity to assume its short-term obligations.
  4. The auditor should evaluate the incidence of this indicator in relation to the results reported by the Cash Flow Statement in the scope of operating activities.

Activity reasons

Activity ratios are used to determine how quickly multiple accounts convert to sales or cash. Total liquidity ratios generally do not provide an adequate picture of a company’s actual liquidity, due to differences in the classes of current assets and liabilities that the company maintains. Therefore it is necessary to evaluate the activity or liquidity of specific current accounts. There are several reasons to measure accounts receivable, inventory, and total asset activity.

They measure the degree of effectiveness with which the company is using its resources. Rotation rates can be used to help short-term creditors estimate the time required to rotate assets such as inventories and cash receivables. This group of ratios measures the effectiveness with which assets are being managed.

Rotation of total assets

The total asset turnover ratio is useful for evaluating a company’s ability to use its asset base effectively in generating revenue. A low ratio can be due to many factors and it is important to identify the underlying reasons. For example, investment in assets is excessive when compared to the value of the items that are produced. If so, the company may wish to consolidate its current operation, perhaps by selling some of its assets and investing the product to achieve higher revenues, or use them to pursue a more profitable area.

It regulates the sales generated by each weight of assets. It determines the level of resources generated with respect to the magnitude of the resources used. It measures both the effectiveness and efficiency of the administration in its use and benefit from the available resources, as well as the sales generated by each investment weight, or the magnitude of the investment necessary to generate a certain sales volume. If the turnover is low, it could indicate that the company is not generating enough sales volume in proportion to its investment.

Rotation and inventory cycle

If a company maintains an excess inventory, it means that it has restricted inventory funds that could be used elsewhere. In addition, there would be high handling costs for the storage of goods, as well as for the risk that they would fall into disuse. On the other hand, if the inventory is too low, the company can lose customers because it runs out of merchandise. The two most important reasons for evaluating inventory are: inventory turnover and average inventory age.

Measure inventory renewal, the more inventory accounts rotate, the more liquidity they have, that is, the faster they become cash. The use of this ratio helps to detect accumulation problems or shortages of merchandise, obsolete inventories, price problems, deficiencies in the commercial area, etc. The cost of goods sold figure in the income statement represents the total cost of all goods that have been transferred from inventory during a given period. Therefore, the relationship between the cost of goods sold and the average balance of inventories held during the year, indicates the number of times inventories that have been replaced throughout the year rotate. Determines the number of times stocks rotate in the year and is also known as the inventory turnover cycle. Its importance is that if it reflects that an entity maintains an excess of inventories it means that it has restricted funds in inventories that could be used elsewhere. In addition, there would be a high cost of handling for the storage of goods as well as the risk that they would fall into disuse. On the other hand, if the inventory is too low, the entity could lose customers because it runs out of merchandise. In addition, there would be a high cost of handling for the storage of goods as well as the risk that they would fall into disuse. On the other hand, if the inventory is too low, the entity could lose customers because it runs out of merchandise. In addition, there would be a high cost of handling for the storage of goods as well as the risk that they would fall into disuse. On the other hand, if the inventory is too low, the entity could lose customers because it runs out of merchandise.

The ideal would be to be able to add the inventories at the end of each month and divide by 12 to obtain an average inventory, however this information is not available, the closest substitute is to obtain a simple average by adding the inventory figures at the beginning and at the end of the year.

The result gives the number of days that the goods are renewed in a given period of time. The comparison provides a valuable indication of efficiency and inventory control. Relatively slow replenishment means overinvestment in commodities, relatively rapid replenishment contributes considerably to capital replenishment. For any business there is a normal period in which inventories must be sold or converted into cash or accounts receivable; Moving the goods beyond this period means that extra-financial pesos are incurred in fixed and administrative costs, all of which must be paid with the sales margin.

In the event that cost of sales is not available, sales are used as a substitute, although this would no longer be an appropriate definition, especially in high-margin businesses, since sales contain a profit margin that is not included. in inventories. Occasionally, inventory is designated at the end of the year instead of its average. In any case, whatever definition you use, it must be invariable for its comparisons to be meaningful.

When you are in the presence of an industrial company to the Inventory of finished goods. It may be valuable to calculate in some companies a Raw Materials Inventory Rotation and it would be defined as the purchases of Raw Materials divided by the average of the Raw Materials inventory of the period and would indicate how many times the inventory of raw materials is acquired during the period.

Industrial business

  • It is expressed in times

 

  • Expressed in: days

It expresses the average number of times inventories rotate during the year. It indicates the days that the goods remain in stock on average.

Accounts receivable rotation and cycle

  • Accounts receivable ratiosare made up of accounts receivable turnover and the average collection period. The accounts receivable turnover ratio indicates the number of times accounts receivable are collected during the year. It is calculated by dividing) net sales on credit (if total sales are not available then) by the average accounts receivable.
  • Average accounts receivableIt is usually found by adding accounts receivable at the beginning and end of the period and dividing by two. Although the average accounts receivable can be calculated annually, quarterly, or monthly, the ratio is more accurate when a shorter period is used. In general, the higher the turnover of accounts receivable, the better, since the company is properly charging its clients and these funds can be invested. However, an excessively high ratio may indicate that the company’s credit policy is too stringent and the company is not deriving profit potential through sales to customers in the high-risk classes. Note that here, too, before changing your credit policy,
  • Accounts receivable turnoveris calculated by dividing net sales to credit by the average balance of accounts receivable. Ideally a monthly average of accounts receivable should be used including only credit sales in the sales figure.

The collection period (days in sales receivable) is the number of days it takes to collect an account.

It is convenient to compare this index with the company’s credit policies. If these remain unchanged and the turnover increases, it would be significant of a weakness in the management of collections.

  • An additional analysis tool to this rotation is the balance aging analysis.
  • Rotation and cycle of Accounts Payable. The rotation of accounts payable is calculated as follows:

Rotation of accounts payable and payment period.

It is expressed in: times

It is expressed in days. It measures the efficiency in the use of supplier credit. Indicates the number of times accounts and bills payable go through purchases during the year. It expresses the number of days that accounts and bills payable remain payable. It represents the average term of payment to suppliers and can show efficiency in obtaining supplier credits (very useful if it is complemented by the supplier’s sales policy).

Debt reasons

Solvency is the ability of a company to pay its long-term obligations when they are due. A solvency analysis focuses on the long-term financial structure and operations of the company. The type of long-term debt is also taken into account in the capital structure. Furthermore, solvency depends on profitability, since a company will not be able to pay its long-term debts unless it makes a profit. When debt is excessive, additional financing must first be obtained from equity sources. Management may also consider deferring the debt due date and staggering payment dates. Below are some reasons of influence or solvency.

Debt or indebtedness ratio

The debt ratio compares total liabilities (total debt) with total assets. This indicates the percentage of total funds that were obtained from creditors. Creditors would prefer to see a low debt ratio because there is greater loss protection for creditors if the firm files for bankruptcy.

It measures the percentage of total funds provided by creditors. This reason responds to the question: What part of the asset was financed with the debts? From the point of view of a creditor, the lower the ratio, the better, since this means that the shareholders have contributed to the business with most of the funds and therefore the margin of protection of the creditors against a decrease in assets is high. This reason also involves the ability to pay in the long term.

It is expressed in: Times or percents

It measures the portion of debt-financed assets. Indicates the ratio or percentage that represents the total debts of the company in relation to the resources available to satisfy them. It helps determine the ability of the company to cover all of its obligations. An indebtedness of 60% is considered manageable. A lower indebtedness than the previous one shows the ability to contract more obligations and a higher indebtedness shows that it can make it difficult for you to grant more financing.

Debt / equity ratio

This reason is important for measuring solvency, since a high level of debt in the capital structure can make it difficult for the company to pay the principal and interest charges when due. Furthermore, a high debt position runs the risk of running out of cash under adverse conditions. Also excess debt will result in less financial flexibility, as the company will have more difficulty raising capital during a constraint on the money market. The debt / equity ratio is calculated as follows:

It is expressed in: Times

It expresses the relationship that exists within the capital structure between the resources provided by third parties and the equity. Indicates the proportion that the liability represents in relation to the liquid capital. It provides an insight into the company’s overall debt situation as a measure of its ability to raise funds in an emergency or over-reliance on third-party funds. The recommended value is around 1. If this ratio were higher, it would be difficult to obtain new sources.

Indicates the strength of the heritage; determines to what extent the business is in the hands of the owners or creditors. It indicates the company’s debt potential and could be an indication of whether or not the capital is sufficient to operate normally. There are companies that can successfully operate with liabilities greater than their stockholders’ equity. This index measures only the proportions of the financial structure and is not indicative of the company’s ability to meet its credit obligations.

Autonomy or self-financing

It is expressed in times

It is the relationship that exists within the capital structure between the resources provided by the shareholders or owners of capital and total assets.

This reason is considered by analysts as one of the most important, together with the current reason when it comes to indicating credit strength and answers the question: What part of total assets was financed with shareholders? A low equity ratio indicates extensive use of leverage, that is, a large proportion of financing provided by creditors, and if it is high, it indicates that the company is making little use of it.

The effect of leverage also known as trading with equity based on results of operations can be:

  • Positive: When the return on invested capital is greater than its cost.
  • Negative: When the return on invested capital is less than its cost.
  • Neutral: When the return and cost of that capital are equal.

Profitability reasons

Profitability can be seen from three different points of view:

  • Commercial: represents what profit the company generates for each peso sold.
  • Economic: represents what benefit the company generates from the use of its assets.
  • Financial: represents what benefit shareholders obtain with the investments they make in the company.

An indicator of good financial position and the efficient way in which a company is managed is the ability of the company to earn a satisfactory profit and reinvest. Investors will be reluctant to partner with an entity that has poor earning potential as the stock market price and dividend potential will be adversely affected. Creditors will avoid companies with poor profitability, since the amounts owed to them may not be paid. The absolute profit in dollars by itself is of little importance unless it is related to its origin. The main reasons that measure the results of operations are summarized below.

Gross profit margin

The gross profit margin reveals the percentage of each dollar that remains after the company has paid for its merchandise. The higher the gross profit earned, the better. Gross profit equals net sales, less cost of goods sold.

It reflects the proportion that the gross profits obtained represent in relation to the net sales that produce them.

Profit margin. The ratio of net income to net sales is called the profit margin and indicates the profitability generated by income and is therefore an important measure of performance in operations. It also provides clues to pricing, cost structure, and production efficiency.

It measures the ratio or percentage that the net profit represents in relation to the net sales that are analyzed, that is, it measures the ease of converting the sales into profit.

Of operating expenses incurred

They are expressed in: Reason or percentage.

It measures in what proportion the operating expenses incurred represent in relation to the sales of the period analyzed.

Financial profit

It measures the ability to generate profits with the capital contributed and represents the proportion of profits that will allow the resources contributed to be recovered. The more satisfactory the higher the return on investment is.

It measures the degree of utilization of the resources invested by the partners, profit for each peso invested. It determines the percentage of the return obtained by the owners in relation to their investment with their own resources or the benefit for each peso of their own investment. Evaluate the efficiency of the capital invested with own resources. In the case of private investors, their focus is mainly on earnings per share.

Profit on total assets or Economic Return

Indicates the efficiency with which the administration has used its available resources to generate income.

It measures the return on all the capital invested in the business. It reflects the use of the entity’s resources, the effective capacity of the entity to produce profits with the available assets and represents the proportion of the profits that will allow recovering the invested resources. The better the higher the return on investment.

It measures the return obtained for each peso invested in assets.

Reflects the percentage of return obtained with respect to the total investment and the benefit for each total investment weight. It essentially reflects the effectiveness and efficiency in the use and benefit of the total investment.

Growth Ratios.- They measure the ability of your administration to maintain the economic position of the company in the growth of the industry economy.

 

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