CSS Solved Business Administration Past Papers | How ratio analysis is a useful management tool to improve understanding of financial health for different stakeholders including creditors, investors, and management?
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Topic Breakdown:
Ratio analysis is considered to be the pillar of financial health. All the firm’s stakeholders rely on this analysis to arrive at a decision. There are several categories of financial ratios that serve different purposes for stakeholders.
Topic: Ratio Analysis
Subject: Financial Management
Introduction:
Ratio analysis is one of the critical tools that stakeholders use to make decisions about the firm’s future. While the creditors are more concerned with the firm’s liquidity position and debt management, the investors are interested in the stock returns and dividends. Likewise, the management is most concerned about the activity ratios to assess the efficiency of their assets. Therefore, ratio analysis is useful for all the stakeholders in one way or the other.
Categories of financial ratios:
- Liquidity Ratios: the firm’s ability to pay off short-term debts.
- Activity Ratios: how efficiently the firm is using its assets.
- Debt Ratios: the firm’s ability to pay long-term debts.
- Profitability Ratios: how profitably the firm is using its assets.
- Market value Ratios: gives an idea of how investors view the firm and its future prospects.
Ratio analysis and creditors:
One integral part of the financing for any firm is creditors. They usually extend short-term loans that are payable within a year; thus, they are known to be the most sensitive and crucial part of the balance sheet. One category of ratio analysis that creditors are interested in is liquidity ratios.
Liquidity Ratios:
Liquidity ratios are the firm’s ability to meet short-term obligations. It further depicts the firm’s solvency position in adverse times.
Types of Liquidity Ratios:
- Current Ratios:
The current ratio is a part of the liquidity ratio, which is the firm’s ability to meet its short-term obligations. - Quick Ratios:
Also part of the liquidity ratio. It shows a firm’s ability to meet current liabilities with its most liquid assets. This ratio serves as a supplement to the current ratio to give a clear indication of liquidity.
Turnover Ratios:
They are also known as the activity or efficiency ratio. Turnover ratios are actually the measure of how efficiently the firm is using its assets. Some aspects of turnover ratios are closely related to liquidity ratios.
Importance:
For creditors, this is the most important category as it explains the firm’s ability to pay back its obligations. The higher the liquidity ratios, the more satisfied the creditors will be with the firm’s financial health. Moreover, if the firm has troubled financial health may decide to slower its accounts payable and increase borrowing, consequently leading to a rise in current liabilities as compared to its current assets. However, a learned creditor may not rely solely on liquidity ratios and also want to study the quality, composition and size of current assets.
Turnover ratios are an indication of how effectively the firm is utilizing its assets. The shorter the inventory cycle, the more cost-effective and efficient the firm’s performance is; likewise, the smaller the accounts receivable cycle, the more liquid and stable the firm is. Moreover, efficient accounts receivable reduce the risk of bad debts, hence the financial burden. The inventory and accounts receivable combine to make an operating cycle, which should have fewer days as possible. The third indicator of the efficiency ratio is the payable period; the longer it is, the more dissatisfied the creditors will be. A payable period or inventory cycle that seemingly exceeds the industry averages is an anomaly that alerts both the management and creditors.
Ratio Analysis and Management:
Management is an integral part of any firm; its core focus is to generate maximum profits for its stakeholders. For this the management must ensure that its assets are used in an optimum possible manner with the highest efficiency. Another aspect that the management is interested to study is the firms cost and operational efficiency. The relationship between the profits, sales and investment is the key to understanding firm’s operational efficiency.
Turnover Ratios:
They are also known as the activity or efficiency ratio. Turnover ratios are actually the measure of how efficiently the firm is using its assets. Some aspects of turnover ratios are closely related to liquidity ratios.
Types of Turnover Ratios:
- Receivable Turnover:
It provides insight on how successful the firm is in its collection. Bad debts at occasions suck in a large chunk of company’s profits. It can also be measured in number of days.
- Payable Turnover:
At occasions a firm wants to study its own promptness in paying to the suppliers.
- Inventory Turnover:
The third of the turnover ratios is related to how effectively the firm is maintaining its inventory. Although higher ratio is a good indicators but on instances it indicates hand to mouth existence.
2- Profitability Ratios:
This ratio is examined on two different scales. One it shows profitability in relations to sales other it depicts profits in relation to investment. In simple words it is amount of profit earned on the money invested and that earned from sales.
Types of Profitability Ratios
- Gross Profit Margin:
This is the profit margin on sales. It is a measure off firm’s efficiency and pricing.
- Net Profit Margin:
This is also the profit margin on sales. It reduces all expenses and taxes from the sales amount to give profit per dollar of sales.
- Return on Investment:
This group of profitability ratio takes into account the profit on investment. It is the per dollar profit earned on total investment (assets).
Importance:
Turnover ratios are an indication of how effectively the firm is utilizing its assets. The shorter the inventory cycle the cost effective and efficient the firms performance is; likewise, smaller the accounts receivable cycle the more liquid and stable the firm is. Moreover, an efficient accounts receivable reduces the risk of bad debts; hence the financial burden. The inventory and accounts receivable combine to make an operating cycle; which should have fewer days as possible. The third indicator of efficiency ratio is the payable period; the longer it is the more dissatisfied the creditors will be. A payable period or inventory cycle that seemingly exceeds the industry averages is an anomaly that alerts both the management and creditors.
Another area of concern for the management is the costs and pricing associated with its product or service. These ratios give the management an idea of the production and operating costs useful to assess the return against per dollar of investment. Profitability ratios are of utmost importance as they attract almost all stakeholders especially management and investors.
Ratio Analysis and investors:
In almost all the corporations, one that are lenders or borrowers-giving money for a long run. While the others are shareholders, that invest money in the company in return for profit and ownership rights. Moreover, there are also strategic decisions in businesses like mergers, acquisitions and issuing new stocks. Businessmen never invest in any business unless they have a holistic view of companies’ financial health.
3- Debt Ratios:
Debt ratio is the extent to which firm is financed by debt. There are two ways to finance debt and equity. More the debt financing more dangerous it is for future financial stability of firm.
Types of Debt Ratios:
- Debt to Equity Ratio:
This ratio shows the extent to which firms finances are financed by debt. This ratio will vary according to the availability of cash flows and nature of business.
- Debt to Total Asset Ratio:
It serves the same purpose as debt to equity ratio. It show the degree to which firms is financed by debt.
- Times interest earned:
It is a measure of the firm’s ability to meets its annual interest payment.
Profitability Ratios:
This ratio is examined on two different scales. One it shows profitability in relations to sales other it depicts profits in relation to investment. In simple words it is amount of profit earned on the money invested and that earned from sales.
Types of Profitability ratio:
- Return on Assets:
It is the measure of rate of return on total assets.
- Return on Equity:
It measures the rate of return on common stockholders’ investment.
- Return on Investment:
This group of profitability ratio takes into account the profit on investment. It is the per dollar profit earned on total investment (assets).
Market Value Ratios:
The final and most important category of ratios for the investors is market value ratios. They give a detailed analysis of how well their investment is placed as compared to the others in the industry.
Types of market value ratios:
- Price earnings ratio:
It depicts the dollar amount an investor will pay to earn one dollar of current earning. - Market/Book ratio:
It is a comparison of stocks market price compared to its book value. - Enterprise Value:
It gives an assessment of relative market value of all the key financial claims by the firm.
Importance:
The firms financing composition involving the debt and equity is of utmost importance for both the lenders and investors. Lenders are always reluctant to invest in a firm that is heavily debt financed or its assets are unable to pay back the debt holder’s completely. Similarly investors and lenders are also keen about the firm’s profitability. The return on stock holder’s investment and the amount of assets used is instrumental in decision making.
Market value ratios relate the firm’s stock price to its earning and book value; thus giving an assessment of whether the investor should invest in this company or not. Another purpose of these ratios is to assist the bankers in deciding the value of newly issued shares. Moreover company also uses such analysis to determine the value of the firm when going for a merger.
Conclusion:
To conclude, ratio analysis gives a bird’s eye view of the company’s financial health and standing as compared to the industry. All the stakeholders including investors, management and lenders use ratio analysis as guidance to arrive at a decision. Although, their purposes and needs are different about key financial claims but all the stakeholders consider it the first step in analyzing the firm’s financial health.
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