After a brief introduction to five different types of ratios in the last article, let’s take a look now how to define those accounting ratios with more details. These ratios will help us to analyze business’s profitability, efficiency, liquidity, debt and investment attractiveness.
Profitability Ratios:
4. Return on Capital Employed (ROCE)
Liquidity Ratios:
2. Quick Ratio (Acid-Test Ratio)
Efficiency Ratios:
1. Stock Turnover (in times) & Stock Turnover (in days)
2. Debtor Days
Debt Ratios:
1. Gearing
Investor Ratios:
A. CAPITAL GAIN:
B. DIVIDENDS:
These accounting ratios tend to be relevant to profit-oriented businesses rather than for non-profit business organizations. It is because profit is a key objective for most private-sector businesses acting as a measure of a firm’s success.
1. Profitability Ratios
Profitability Ratios measure how successful a business has been at earning profits from sales and capital employed in the business.
Profitability Ratios are of particular interest to managers, employees and investors who want to know how well a firm has performed financially this year comparing with previous years and against the performance of other businesses. These ratios are used to assess how successful the managers of a business have been at converting sales revenue into both Gross Profit and Net Profit Before Interest and TAX, as well as controlling the cost of production and expenses. Also, how much profit has been generated from the available capital used by the business.
Two main Profitability Ratios specifically related to how much profit is generated from Sales Revenue include:
Other Profitability Ratios specifically related to measuring how effectively the capital has been used to generate Net Profit Before Interest and TAX include:
4. Return on Capital Employed (ROCE)
Both Return on Equity (ROE) and Return on Capital Employed (ROCE) measure a company’s operational efficiency when it comes to using capital. Return on Equity (ROE) considers only the shareholder capital employed, hence shows how effective shareholders’ capital is managed by the managers. Return on Capital Employed (ROCE) considers the total capital employed including long-term debt (mortgages, long-term bank loans and bonds), hence shows the efficiency of a business operation.
2. Liquidity Ratios
Liquidity Ratios measure the ability of a company to pay its immediate debt (Short-Term Liabilities), from its Current Assets. These ratios are used to judge the short-term financial health of a business, its liquidity. Liquidity is the ability of a firm to pay its short-term debt obligations.
Liquidity Ratios are mainly concerned with Working Capital of the business. If there is too little Working Capital, then the business could become illiquid, therefore unable to pay back short-term debts. If it has too much money tied up in Working Capital, then this money could have be used more effectively and profitably by investing in other assets.
Two main Liquidity Ratios include:
2. Quick Ratio (Acid-test Ratio)
Business’s creditors such as suppliers, lenders, employees, investors and the government will be looking at Liquidity Ratios because they want to know what is the likelihood of getting back the money they are owed.
3. Efficiency Ratios
Efficiency Ratios measure how well the business’s managers are using the firm’s available resources – how well the business is performing in terms of its daily operational efficiency.
Efficiency Ratios are of particular interest to managers and shareholders. These ratios can be used to measure the amount of time taken to sell inventories, the average number of days taken to collect money from debtors and the average number of days it takes to pay creditors.
The two main Efficiency Ratio related to managing inventories include:
1. Stock Turnover (in times) & Stock Turnover (in days)
The two main Efficiency Ratios related to giving and receiving trade credit include:
2. Debtor Days
4. Debt Ratios
Debt Ratios measure the level of long-term debt the business currently has in relation to total capital employed. And, to measure how effectively the business is in terms of paying interest on that debt from Net Profit Before Interest and TAX.
Debt Ratios are of particular interest to managers and lenders such as banks, microfinance providers, etc. These ratios can be used by existing and potential lenders to assess the degree to which the business is relying on long-term loans or bonds to finance its operations. It will also shed some lights on a business’s financial strategy.
The two main Debt Ratios include:
1. Gearing
Total capital employed includes Shareholder’s Equity and Long-term Liabilities in Balance Sheet. Specifically, Retained Profit plus Share Capital plus mortgage plus long-term bank loan plus debentures.
5. Investor Ratios (Shareholder Ratios)
Investor Ratios measure how attractive public limited companies are for current and future shareholders to purchase.
Investor Ratios are of particular interest to current shareholders and prospective investors who need to assess the rate of return on shares and risk when making an investment to buy shares.
Buying shares in a public limited company can generate earnings in two ways:
A. Capital gain. Made by the share price rising. Share price is a quoted price of one share traded by institutions and individuals on the stock exchange.
B. Dividends. Earned when a part of the company’s Net Profit After Interest and TAX is paid out to shareholders. Companies pay dividends annually, quarterly or monthly to shareholders unless all profits are retained, profits are too low or losses were made.
Investor Ratios help to indicate the prospects for financial gain from both of these methods.
The two Investor Ratios specifically related to a share price, hence capital gain, include:
Investor Ratios specifically related to dividends include:
In summary, the aforementioned five different types of ratios are used to analyze financial information from Profit and Loss Account (P&L Account) and Balance Sheet in order to judge the performance of a business. These ratios provide business stakeholders with numerical information to help them assess various aspects of a business organization for decision-making and determining business attractiveness.
