Financial ratios constitute some of the key indicators of a firm or organization’s performance or rather financial situations. In some cases, financial ratios serve as indicators of the possibilities of a firm’s state of bankruptcy. Among the financial ratios, as used by wide spectra of firms, include liquidity ratios, dividend policy ratios, asset turnover ratios, profitability ratios, and financial leverage ratios amongst others. This short paper examines the relevance of four of these ratios.
The capability of a firm to realize short-term responsibilities reflects itself through the liquidity ratios. Banks use a firm’s liquidity ratio when extending short-term loans to the firm. The quick ratio, Cash ratio, and Current ratio entangle the three commonly liquidity ratios widely calculated by firms. As a shield from risks, short-term creditors prefer higher current ratios. On the other hand, shareholders may prefer low values of current ratios since this indicates the utilization of the better part of their assets in the organization’s endeavors of growth. Business Knowledge Centre reveals how some companies, however, prefer maintaining high current ratios so that they may be able to remain solvent especially during times of low downturns (2010, Para.1). Some assets, however, may prove impossible to liquefy quickly while others may feature a fair deal of uncertainties in terms of their actual liquidation values. Consequently, the computation of liquidity ratio using this approach presents a substantial drawback.
The quick ratio refers to the deference between current assets and inventory, as a fraction of current liabilities. According to Business Knowledge Centre, “The assets used in the quick ratio are cash, accounts receivable, and notes receivable” (2010, Para.2). A more conservative liquidity ratio is the cash ratio, expressed as a sum of cash and marketable securities as a fraction of current liabilities. This liquid ratio provides a reflection of an organization’s ability to meet its current liabilities in case the organization requests some unexpected payments.
The debt ratio, debt to equity ratio, and interest coverage ratio constitute the financial leverage ratios. Unlike, liquidity ratios, financial leverage ratios indicate the capacity of an organization to remain solvent in the long run. With reference to Business Knowledge Centre, “Financial leverage ratios measure the extent to which a firm is using long-term debts” (2010, Para.3). Banks show much interest in the higher financial leverage ratios for a firm since it indicates how the firm can pay interests for its long-term debts, as it attempts to obtain more funding. For shareholders, it is their interest to be assured that their company is competitive and self-sustaining. Consequently, high financial leverage ratios are crucial to them.
Varying measures of excellence of a business in its profit-making endeavors are measured using profitability issues. The rate of return on assets indicates a firm’s ability to utilize the assets in making a profit. On the other hand, return on equity gives an indication of the profit generated as a fraction of every dollar invested. Another pertinent profitability ratio is the gross profit margin ratio, which measures the relationship between the costs of goods sold and total sales realized. Higher profitability ratios are desirable by the banks as a means of indicating diminished leading risks. For the case of shareholders, high profitability ratios are desirable since they reflect the firm’s capacity to make profits, which is the main interest of the shareholders.
Lastly, according to CPA Class, “Dividend policy ratios provide insight into the dividend policy of the firm and the prospects for future growth” (2009, Para.10). There are two commonly employed dividend polity ratios; dividend payout and dividend yield. Dividend payout refers to the dividend per share as a fraction of earnings per share. Dividend yields, on the other hand, are the dividends per share expressed as a fraction of share price. Higher values of these ratios, however, do not give an indication of firm’s future prosperity, although, higher profits and returns on investment are the chief interest of shareholders and leading institutions including banks.
Business Knowledge Centre. (2010). Financial Ratios. Web.
CPA Class. (2009). Accounting Ratios for Financial Statements Analysis. Web.