Financial ratios are part of monitoring Budget and cash flow
An economic rate requires reasoning the connection between two figures and asserting the meaning of that correlation. Financial ratios used to compare the past performance with actuals help in the forecasting of budget and cash flow.
There are four types of ratios
- Profit ratio
- Efficiency ratio
- Liquidity ratio
- Solvency ratio
Profit ratio
It is used to indicate the profitability of the business.
- The gross profit margin.
- The net profit margins
- The return on capital invested in your business.
The Gross Profit margin ratio
It is the most critical ratio. It is used to assess the relationship between profit and sales.
Gross profit*100/ Sales = Gross profit margin
The net profit margin
It is not that useful like the gross profit margin but still can be helpful. The net profit arrived after deducting all the expenses apart from the tax for the business.
The return on capital ratio
From this ratio measurement of income is generated from the capital invested in the business. It is also used to measure the revenue generated from other forms of investments in the industry.
Profit charging interest and tax*100/Total capital employed = Return on equity
Efficiency ratios
- Efficiency ratio divided into three areas
- Debtor’s turnover ratio: Collection period
- Creditors turnover ratio: Payment period
- Stock turnover ratio: Average stock holding period.
Liquidity ratio
These are measurements used to test the ability of an organization whether it can pay back the short-term agreements.
These are mostly used by potential creditors and lenders to decide whether to extend the debts or loan agreements to a company.
Current ratio
Current assets/Current liabilities = Current ratio
Currents assets are, stocks, cash at bank, debtors, work in progress and cash in hand,
Current liabilities are Creditors, loans payable, bank overdraft does not include long-term loans.
Quick ratio
It is a sign of its ability to meet long-term financial commitments and continue its operation in the foreseeable future and attain its goals. An organization should be analyzed over time and in the circumstances of the industry the company controls in.
Basically, companies should focus on continuing to keep this ratio that maintains adequate control against cash crunch for a short-term period because it is detrimental to any organization, given the variables in a particular sector of business, among other considerations.
It includes cash in hand and at bank and debtors
Quick assets/ Current liabilities= Quick ratio.
Solvency ratio
It helps to find out the solvency of your business. If the liabilities exceed your total assets your company is insolvent.
Total assets of the business/ Total liabilities of the business= Solvency ratio
Why do we use ratios in a business?
It identifies positive and negative financial trends in your store. Then we used to compare the financial state of your company with others in your industry. In addition, it helps you to identify the past and present performance and then the weaknesses and strengths in business. It helps to analyze financial statements which are important for all the stakeholders of the company, besides you can easily understand the profitability of the company. Also, when using a financial ratio, you will get to the operational efficiency of the company.
Quiz
Why do companies use financial ratios?
To identify the past and present performance.
The business owner must know both situations as far as the performance of the business is concerned; if not, they might face a position to lose the business.
You can use it to assess the relationship between sales and the profit
A business could have many sales but might also meet the loss because of some mistakes in running the company; if you sell on credit, you might forget to collect the money.
Finding out the solvency of the business is vital.
The liabilities might exceed the assets in a business without even knowing, so you must use this ratio to check that.
To ensure whether your business can get loans if needed.
The potential creditors and lenders mostly use the liquidity ratio to decide whether to extend the debts or loan agreements to a company.