A financial ration is an important and simple method of interpreting the numbers that are contained in statements.
Four types of financial ratios are:
Asset turnover ratios
These show the firm’s competence in the utilization of its assets and they are divided into two categories namely: inventory turnover and receivables turnover (Richard, 2007). The inventory turnover is assessed by dividing the inventory by the annual cost of the goods sold while the receivables turnover shows how fast the accounts receivables are collected by the firm.
They provide the data about the firm’s aptitude to live up to its short-term financial obligations and are defined by two mostly used ratios. One is the current ratio which is the current asset ratio to current liabilities while the quick ratio is the alternative liquidity measure without the inclusion of current assets inventory.
They refer to the varying success measures of the firm at making profits. It is divided into three categories namely: gross profit margin which is the gross profit realized on sales; return on assets which is the range of competence of the assets of the firm to make profit; and return on equity which is the bottom measure for stakeholders and calculate per every dollar ploughed back in the stock of the firm.
Dividend policy ratios
They give information regarding the firm’s policies and future visions. Frequently used ratio terms are: dividend yield is the dividend per share divided by the share price; and payout ratio which is the dividends per share divided by the earnings got from every share.
What do the financial ratios tell you about a firm?
The financial ratios give an analysis formation and it assists us in understanding the data of a company regarding its financial details.
It is important for banks to understand these ratios because they play the part of the bridge between the lenders of money and the borrowers and so they must have detailed financial statements to enhance a smooth flow of money.
The importance of an investor in knowing the financial ratio of a firm to know what the ratios represent but if that is overlooked, an investor can invest in a company with many debts which can barely survive or in a company that generates little returns and so if those are not recorded, the investment may be a waste of money.
Richard, B. (2007). Financial ratios: how to use financial ratios to maximise value and success for your business. Burlington: Elsevier.