Financial Planning is done to achieve the strategic goals in any business. When you achieve your objectives, you try to measure your actual performance. For that, ratio analysis is one of the key tools to analyze performance, find strengths and weaknesses, and highlight the areas that need to be improved.
With important financial details like current ratio, debt to equity, inventory turnover ratios, etc. you get a bird’s eye view of how well the company is performing when compared to other players in the industry.
Commonly Used Ratio Types
1. Liquidity Ratios:
As the name suggests, liquidity ratios indicate the strength of the company to pay its short-term liabilities. Therefore, we compare companies’ current assets with their current liabilities to draw some conclusions. The higher this ratio comes out, the stronger is the company’s position to pay out its short-term debts. Current Ratio and Quick Ratio are the two types of liquidity ratios.
2. Leverage Ratios:
Leverage ratios measure the ability of a company to meet its financial obligations. Every company has a combination of equity and debt. So, these ratios measure what proportion of the company’s capital is borrowed and whether the company is capable enough to repay its debts in the long term when they are due.
Examples: Debt to Equity Ratio, Consumer Leverage Ratio, Equity Multiplier, etc.
3. Profitability Ratios:
Profitability Ratios tell you how efficient a company is in using its assets so as to generate more and more profits. These ratios can then be compared with the past performance of the same company or current performance with the other players in the market.
Examples: Return on Asset Ratio, Return on Equity Ratio, etc.
4. Asset Management Ratios:
Asset Management Ratios will tell you how much sales the company is generating using its assets. These ratios will further help the company in designing and modifying the credit policies and inventory management systems.
Examples: Total Asset Turnover Ratio, Inventory Turnover Ratio, Receivables Turnover Ratio, etc.
Why are Financial Ratios Crucial for Business?
Financial ratios are vital for all stakeholders in a company whether they are management of the company, shareholders of the company, investors, creditors, employees, tax authorities, or the government. Let’s see how!
1. Analysis of Financial Statement:
To read a full annual report of a company for any stakeholder is a cumbersome task but going through financial ratios becomes quite handy. Thus, you get an overview of financial statements without reading income statements and balance sheets.
For example, Creditors will look for Debt/Equity or Debt/Asset, while a retail investor might search P/E or Dividend Payout.
2. Evaluating Efficiency of Company:
The efficiency of a firm can be easily evaluated with the financial ratios. You can easily track the profitability of the company as well as how well the company is doing in its day-to-day business.
For example, Return on Asset will tell how much income the company is generating by deploying its total assets, return on equity tells how much profit the company is generating with shareholders’ money.
On the other hand, turnover ratios reveal how much sales a company is generating using its assets.
3. Helps in Planning and Forecasting:
When past ratios are derived and analyzed, it helps management much in planning and forecasting. Management while considering these ratios prepare budgets and frame the policies to improve the efficiency of the company.
4. Identifying Risk and Taking Corrective Actions:
Identifying risks and taking corrective action is a vital part of any business and this activity should be performed at regular intervals. For example, Financial leverage will show us the picture of how much debt the company is using to finance its operations, Operating Leverage will help the company to determine break-even point as well as shows how its costs are structured.
5. Comparison with Competitors:
The great Theory of Relativity applies everywhere. To measure the performance, it is not enough to review own past performance only, but equally important to compare with the competitors in that particular industry.
Therefore, management, as well as investors, compare the performance of a company to competitors to understand relative efficiency and profitability. It’s then easy for the company to perform a SWOT analysis and prepare plans on how to counter threats and overcome weaknesses.
6. Reliable Source of Communication:
People can lie but metrics generally don’t. Therefore, financial ratios are an effective and reliable source of communication to all the stakeholders of the company. They are simple and easy to understand and give an overview of the business performance. Thus, investors also include them in their studies and then take decisions accordingly. Strong ratios make the company attractive to invest in and boost the investors’ confidence.
7. Liquidity of the Firm:
Creditors and Investors are more concerned with these ratios apart from the management. The financial health of a company is determined by measuring the liquidity of the company. Whether the company is capable of paying its debt makes a lot of difference. If the company has enough capacity to pay its short-term (12-month) debts, it is considered good.
For example, the Current Ratio will compare the current assets of the company with its current liabilities to conclude how capable the company is to pay its short-term debts.
8. Helps in Decision Making:
Important Financial Ratios reflect all the necessary information about the firm’s liquidity, solvency, efficiency, financial position, profitability, and trends. When the complete picture comes in front of management, it helps them in making better decisions, forming better policies, and modifying strategies to achieve the objectives of the company.
9. Utility to Employees:
Attracting and retaining talent is also indirectly related to the performance of the company which is reflected by its key ratios. This is because employees’ salaries and fringe benefits also depend on the profits earned by the company.
Ratio Analysis: Is it Important?
Ratio Analysis plays a pivotal role in Financial Planning. To check performance and understand the ability of any company, they are very important for management as well as other stakeholders.
Investors also explore all angles from liquidity to solvency to efficiency and profitability and compare them with the industry peers to build confidence and trust. On the other hand, companies continuously take corrective actions and keep on planning how to improve the business and its financial parameters. What do you think aren’t these crucial for any business? Do share your views.