From the very emergence of a business, the financial decision process begins, how to act, where to obtain the funds to acquire the initial capital, what financial policy to draw, all these are questions to be answered in the field of finance, and they are also answers To which a manager, an analyst or a financial administrator must give a solution, success in decisions will be the future of the business and therefore, the final result of its management.
Among the functions performed by a financial administrator, financial analysis constitutes the main function. Financial ratios are a widely used technique for conducting financial analysis and in practice, together with comparison (from which it is derived), they represent primary tools used by the financial analyst.
This document includes a summary of the financial ratios most discussed in the literature on the subject and most used in the daily practice of financial analysts and managers.
Development
The use of Financial Ratios or the so-called Ratios, (the term Ratio comes from the English, and means ratio or quotient) is very useful in financial analysis especially.
The so-called Ratios generally represent the quotient between different quantities that result in a new quantity. They can also constitute absolute relations of difference between two quantities.
To establish a new Financial Ratio, the fundamental requirement is that there be a close relationship between the associated magnitudes. All must be evaluated in the context of the entity being analyzed and no useful reason can ever substitute for a correct analytical judgment, which is why the role of the analyst is extremely important in this process.
Financial reasons can be classified according to:
The nature of the figures:
- Static (they use the Balance Sheet as source) Dynamic. (they use the Income Statement as a source)
Its meaning or reading:
- Financial (expressed in units of value) Turnover (expressed in number of times) Chronological (expressed in days, months, years)
Your application or objectives:
- Solvency and activity. Leverage or structure. Of profitability. Of growth.
Market ratios are also included in this classification but will not be addressed in this document. Main reasons included in each group:
Solvency and activity reasons.
Solvency ratios measure the ability of the company to meet its obligations within the due date, activity ratios reflect the effectiveness with which the company's assets are managed.
1. Net Working Capital, Working Capital Index or Working Capital = It is the result of the difference between the Current Assets (AC) and the Current Liabilities (PC) of the Balance Sheet.
It expresses the amount of permanent resources that must be kept materialized in current investments so that the cycle of operations is not interrupted. It is generally considered a favorable index when the result is positive, however, it can lead to zero as a result and not be considered a deficient balance as it depends on the characteristics of the activity in question. Organizations with predictable cash flow can work even with negative working capital. It is considered a very effective index for studying the trend of a given company over different economic periods, however, as it is an absolute index, it is not very useful for comparing different companies.
2. Solvency ratio = Reflects the relationship between total assets and liabilities. Shows the relationship between the total resources available to the company and the total from outside or borrowed sources. It is also used as a ratio of debt analysis. This ratio is in fact the inverse of the debt ratio.
3. Current Ratio, average liquidity, index or current ratio, short-term liquidity or solvency = Reflects a relative analysis of Net Working Capital. It is the result of the quotient that expresses the relationship between current assets and current liabilities of a company and expresses the ability of the business to pay its obligations in the short term. The literature reports as an ideal ratio the result of 2, which indicates that for every peso that is owed in the short term, there are two pesos as support, or what is the same, that the company can meet its short-term obligations although current assets decrease by 50%. The expression for this analysis will be the following: (1 - 1: 2) * 100). Its interpretation is subject to the same elements as the previous index.
4. Immediate liquidity, acid test, litmus test or Quick Net Ratio = It is determined by deducting the value of inventories from current assets and this result is divided by current liabilities.
Taking into account that Inventories constitute the least liquid Current Assets, they are discounted from the total Current Assets to know immediately, with what payment resources the company has available. It is considered as an appropriate index when its result is equal to or greater than one. It measures the immediate capacity of the most liquid current assets to cover current liabilities. It involves the immediate conversion of the most liquid current assets into money, to cancel the obligations of current liabilities. A result of 1 is considered the ideal.
The available liquidity index is also used in the analysis of liquidity, also called the bitter ratio or treasury ratio that relates the total Cash between the Current Liabilities, thus showing the organization the real capacity to assume the payment of debts the short term at maturity.
5. Inventory Turnover = It is determined from the quotient between the Cost of Goods Sold and the Average Inventory. Shows the number of times inventory is converted to accounts receivable or cash.
Monthly figures should be used to calculate Inventory. The range in which the result of this ratio must oscillate is very relative because if the level of Inventories is very low, operational interruptions may occur, if it is very high, it implies an opportunity cost for not having invested said capital in other actions. It is usually identified as adequate as the turnover increases. However, a result of 4 is considered an appropriate index, which is equivalent to less than 90 days of inventory.
6. Average Inventory Term = It is determined by dividing 360 by the result of the expression Cost of Goods Sold by Average Inventory or by dividing the average inventory by the daily cost of sale for the period.
Represents the average number of days that an item remains in a Company's Inventory. The time that elapses between the purchase of the item and the Sale of the production. It is generally considered acceptable to the extent that this period decreases, which shows an increase in the turnover of inventories.
In the productive activities, the indicators of inventory rotation of raw materials and finished products are used, due to their significance. In these cases, material consumption and cost of sales are used respectively for the calculation.
7. Turnover of Accounts Receivable = It is determined from the quotient between annual Credit Sales and the Average Accounts Receivable. Shows how quickly the resources invested in accounts receivable are converted into cash, that is, the number of days that, on average, it takes customers to cancel their accounts.
The acceptable result is also relative, since very high rotations may indicate a poor Credit Policy on the part of the Company, however, low rotations are considered to imply a slow recovery of the money pending collection, which may affect the ability to pay the company.
8. Average term of Accounts Receivable = It is expressed in days and is determined from the quotient that relates 360 between the result of annual Credit Sales and the Average Accounts Receivable.
Like the previous ratio, the acceptable level depends on the credit conditions of the Company, however, in general terms, collection cycles that do not exceed 30 days are considered positive.
9. Turnover of Accounts Payable = It is determined through the quotient between Annual Credit Purchases and the Average Accounts Payable.
Indicates the number of times that the company rotates its Accounts Payable in the year.
10. Average term of Accounts Payable or Average Payment Period =
The expression Annual Credit Purchases and Average Accounts Payable is determined from the result of the quotient that relates 360 to the balance.
It is considered acceptable in correspondence with the Credit Conditions granted to the Company. The benefits of the prompt payment discount and the prejudices of the late payment penalty should be assessed. A cycle of 20 days or less is generally considered acceptable.
Aging analysis: Reflects the study of Accounts Receivable and Payable, analyzing from the date of issuance of the same, which has been the efficiency in the Management of Collections and Payments of the Company.
Leverage or structure ratios.
They measure the ability of the company to incur short-term debt with the resources it has. They express to what extent debt financing is used, that is, its financial leverage.
11. Indebtedness Ratio = It is determined from the quotient between Total Liabilities or Total Debt (not including Equity) and Total Assets.
Measures the proportion of Total Assets contributed by Outside Capital, that is, the participation of creditors in financing the company's total assets. The higher this ratio, the greater the Financial Leverage. Its acceptable result depends on how effective it is to use someone else's money, however, analysts agree that it should always be less than 1 (or 100%), A debt of 60% is considered manageable, that is, that each 100 pesos that the company has in its assets, 60 pesos are owed. Higher than this result may mean difficulties for the company in obtaining more financing.
12. Liability-Capital Ratio = It is determined from the quotient that relates the Long-Term Liabilities (external resources) between the Stockholders' Equity or Equity.
Indicates the relationship between Long Term Funds provided by creditors and those provided by owners. It allows estimating the Financial Leverage of the Company.
13. Coverage of fixed assets = It is determined from the quotient that relates to Own Resources (Equity) between Net Fixed Assets.
14. Turnover of Total Assets = Relates annual Sales between Total Assets.
It can be determined for the Fixed Assets and Current Assets concepts. It expresses the efficiency with which the Company can use its assets to generate sales.
Profitability reasons.
They measure the ability of the company to generate profits. They are a measure of the success or failure with which resources are being managed.
15. Return on Investment = Also known as the Dupont Formula, it determines the quotient that relates Net Profits to Total Assets.
It expresses the effectiveness of the administration to produce profits with the assets available.
Breaking down the analysis using the Dupont Formula would be:
- Net Profit Margin = Net Profit divided by Sales Total Asset Turnover = Sales divided by Total Assets.
The Dupont Formula expresses the quotient between these two previous expressions.
16. Economic profitability, Return on assets or Basic Capacity to generate Profits = It is the result of the quotient between the Net Profit (or UAIT) and the Total Net Assets (which includes the Total Gross Assets minus the Depreciation), or the Total Assets. A steady growth in this value indicates better utilization of business facilities.
There is another reason that is called General Profitability, used regularly as the Cost by weight indicator that relates Total Expenses to Total Income. It must always be less than one and indicates how much is spent for each peso of income.
17. Financial Profitability = Relates the Net Profit (UAI) and Equity (Equity).
18. Profitability on Sales, Net Profit Margin, Profit on Sales Margin, Margin on Sales, Net Margin on Sales or Net Profit on Sales Margin = Relates Net Profit (UAIT) and Sales. A return on sales of more than 10% is considered acceptable, although it is convenient to compare this result with that of other companies in the same sector.
Growth Reasons:
They measure the general economic state of the organization, its level of efficiency.
19. Sales.
20. Gross Income.
21. Earnings per Share.
22. Dividends per Share.
Note: The authors include in their classifications different Financial ratios according to the objective of the analysis, the classification that we have offered responds to the most well-known ratios used for economic-financial analysis in most economic organizations.
In the same way, different names are used to calculate identical reasons, so we have included the most referred to according to the literature that has been consulted to prepare this material.
Conclusions
This document offers a summary of the financial ratios most discussed in the literature on the subject and most used by financial analysts and managers in the decision-making process. The document is a reference tool for teachers and students who study and use finance in their daily work.
Bibliography
- Weston F and G. Brigham. Fundamentals of Financial Management.Gitman. Fundamentals of financial management. (Volumes 1 and 2. 2nd part) p. 47-79. Maig and Maig. Accounting. The basis for managerial decisions. 6th part. chap. 20. Analysis and interpretation of Financial Statements. Benítez Miranda M. A and María V. Dearribas. Accounting and finance for the economic training of management cadres. Ministry of Light Industry. January 1997. Borrás F. et al. Cuba. Accounting, auditing and taxation. Development proposals. Faculty of Accounting and Finance of the University of Havana. chap. 4 (The Financial Statements). p. 99-134. MINCIN Finance and Prices Department. Course of Accounting and Economic-Financial Management. Item 2 p. 11-22. Financial statements. Item 10. p. 90-106. June. 1996. Leisle Luis Jaime.Financial planning in modern companies. Navarro Elola Luis et al. The company. Economy and management. Editores SA MIRA. Spain 1998. Topic 4 Economic and financial analysis of the company. P 327-368.
