Financial statements such as the balance sheet and the profit and loss account show a business’ absolute financial performance or absolute financial strength. Absolute financial information provides useful information about a business but in some situations these absolute numbers are not very meaningful when interpreted in isolation.
In order to improve interpretation of financial performance and financial strength of a business accountants and analysts can use financial ratios to analyse financial information so that they get a better and deeper understanding of a business.
Absolute numbers are useful but on their own they may not reveal much about a business for example knowing that a company has made a profit of £1 million or that it made sales of £5 million may not be helpful in understanding how well a business has done or how the business is doing relative to competition. What ratios do is they express these numbers in relative terms such as gross profit margin, net profit margin or turnover ratios. Ratios simplify analysis and allow comparisons to be made between two or more companies.
There are five main types of financial ratios are as follows;
- Profitability ratios
- Liquidity ratios
- Activity ratios
- Gearing ratios
- Investment ratios
Profitability ratios are relative measures of financial performance. The profit and loss account shows information such as the absolute bottom line or profit before interest and tax, net profit and turnover details.
Profitability ratios involve expressing profit as a percentage of another variable such as sales or assets. Examples of profitability ratios include gross profit margin and net profit margin which express gross profit and net profit as a percentage of sales or turnover.
The main liquidity ratios are the working capital ratio and the acid test ratios. The working capital ratio expresses all current assets as a percentage of current liabilities and the acid test ratio is a percentage of all current assets excluding stock or inventory as a percentage of current liabilities. It is more informative and useful for a business owner to know for example; that the business’ working capital ratio is 3:1 and that this is better or worse than the industry standard than knowing that it has an absolute working capital of £100,000.
Activity ratios measures the efficiency of a business and examples of activity ratios include ratios such as asset turnover, stock or inventory turnover, debtors turnover and credit turnover ratios. The stock or inventory turnover for example shows how frequently a business converts its inventory or stock into sales. It will be helpful to the business owner if they know that the business has a stock or inventory turnover of 10 days and that the industry average is say 6 days. Knowledge of this would allow the business owner to ask questions and take actions that would reduce this gap. This information would not be gleaned from absolute numbers.
Gearing ratios measure the financial durability and financial strength of a business. The main gearing ratios are interest cover and financial gearing.
The interest cover measures the number of the times a business will be able to pay its interest commitments from its profits. An interest cover would indicate that a business is durable, financially strong and stable. In the absence of an adverse economic environment such a business will not be exposed to financial bankruptcy.
Financial gearing measures the relationship between equity and funding from debt. The higher the equity the more flexible a business would be therefore there will be less likelihood of it passing up good investment opportunities. A business with a high gearing ratio is considered to be in a weak position as it may not have the flexibility to pursue its strategic business objectives as this may be constrained by covenants placed by its lenders.
Investor ratios are used by investors to underpin the investment decisions. Examples of investment ratios include earnings per share (EPS), price earnings ratio (PE) and earnings ratios. Potential investors use investment ratios to compare investment opportunities because relative measures can help in identifying and isolating good and quality investments better than absolute measures. Investment ratios can also be used to make disinvestment ratios.
Financial ratios measure the relative relationship between two or more variables and businesses can use ratios to understand financial information better. Ratios are used to improve interpretation of financial performance and strength of a business as they help to a better and deeper understanding of a business. The five main types of financial ratios are profitability ratios, liquidity ratios, activity ratios, gearing ratios and investment ratios.