Financial Ratio: index that relates two accounting numbers and is obtained by dividing one number by the other. (Van Horne and Wachowicz, p.132)
The use of financial reasons to carry out financial analysis constitutes a tool that represents the fair reality of the financial situation of any organization. Through its use, it is possible to determine how the firm has performed and evaluate its management.
All people who are surrounded by a changing socio-economic environment, in which the uncertainty of what may happen to their companies is a constant, need to have methods or tools to evaluate their operation in any of the periods of their existence, in the past to appreciate the true situation that corresponds to their activities, in the present to make changes for the good of the administration and in the future to make projections for the growth of the organization.
It is shown that the survival of these entities is closely linked to the management and behavior of all the agents that intervene in the exchange processes (both internal and external) of their daily operation, for this a series of techniques have been implemented to judge all these aspects that can provide at any time useful and accurate information about the company that will help to make quick and effective decisions at a given time.
Fundamentals of financial analysis: • Information • Technical • Interpretation • Decision making • Analysis • Feedback
Financial analysis
The fundamental pillar of financial analysis is contemplated in the information provided by the financial statements of the company, taking into account the characteristics of the users to whom they are directed and the specific objectives that originate them, among the best known and used are the Balance Sheet and the Income Statement (also called Profit and Loss Statement), which are prepared, almost always, at the end of the period of operations by the administrators and in which the capacity of the entity to generate favorable flows according to the data collection is evaluated. accounting derived from economic events.
There are also other financial statements that are sometimes not taken into account and that provide useful and important information about the operation of the company, among these are: the statement of Changes in Equity, that of Changes in Financial Situation and that of Cash flows.
Financial reasons
Financial ratios are the magnitude relationships between two figures that are compared with each other, and are called financial because the various accounts of the main financial statements are used, which can be compared between different periods and with companies that belong to the branch of the business activity studied. (Morales and Morales, p.190)
Categories of financial ratios
One of the most widely used tools to perform financial analysis are Financial Ratios because they allow to measure, to a high degree, the efficiency and behavior of the company. These present a broad perspective of the financial situation, allow to specify the degree of liquidity, profitability, financial leverage, coverage and everything that has to do with its activity.
The Financial Ratios are comparable with those of the competition and lead to the analysis and reflection of the operation of the companies against their rivals. The fundamentals of application and calculation of each of them are explained below.
Liquidity ratios
The liquidity of an organization is judged by the ability to pay off short-term obligations that have been acquired as they mature. They refer not only to the total finances of the company, but to its ability to convert certain current assets and liabilities into cash.
- NET WORKING CAPITAL (CNT): This ratio is obtained by deducting from the current obligations of the company all its current rights.
CNT = Current Liabilities-Current Assets
- SOLVENCY INDEX (IS): This considers the true magnitude of the company in any instance of time and is comparable with different entities of the same activity.
IS = Current Assets / Current Liabilities
- INDEX OF THE ACID TEST (ACID): This test is similar to the solvency index, but within current assets the inventory of products is not taken into account, since this is the asset with the least liquidity.
ACID = Current Assets- Inventory / Current Liabilities
- INVENTORY ROTATION (RI): This measures the liquidity of the inventory through its movement during the period.
RI = Cost of goods sold / Average inventory
- AVERAGE INVENTORY PERIOD (PPI): Represents the average number of days that an item remains in the company's inventory.
PPI = 360 / Inventory Turnover
- ROTATION OF ACCOUNTS RECEIVABLE (RCC): Measures the liquidity of accounts receivable through their rotation.
RCC = Annual Credit Sales / Average Accounts Receivable
- AVERAGE TERM OF ACCOUNTS RECEIVABLE (PPCC): It is a reason that indicates the evaluation of the company's credit and collection policy.
PPCC = 360 / Turnover of Accounts Receivable
- ROTATION OF ACCOUNTS PAYABLE (RCP): Used to calculate the number of times that accounts payable are converted into cash during the year.
RCP = Annual Credit Purchases / Average Accounts Payable
- AVERAGE TERM OF ACCOUNTS PAYABLE (PPCP): Provides a glimpse of the company's payment rules.
PPCP = 360 / Turnover of Accounts Payable
Debt ratios
These reasons indicate the amount of money from third parties that are used to generate profits, these are of great importance since these debts compromise the company over time.
- DEBT RATIO (RE): Measures the proportion of total assets contributed by the company's creditors.
RE = Total liabilities / Total assets
- LIABILITY-CAPITAL RATIO (RPC): Indicates the relationship between long-term funds provided by creditors and those provided by business owners.
RPC = Long-term liabilities / Stockholders' equity
- LIABILITY TO TOTAL CAPITALIZATION RATIO (RPCT): It has the same objective as the previous ratio, but it also serves to calculate the percentage of long-term funds provided by creditors, including long-term debts such as equity.
RPCT = Long-term debt / Total capitalization
The analysis of financial reasons is one of the ways to measure and evaluate the operation of the company and the management of its administrators
Profitability reasons
These ratios allow you to analyze and evaluate the profits of the company with respect to a given level of sales, assets or the investment of the owners.
- GROSS PROFIT MARGIN (MB): Indicates the percentage that remains on sales after the company has paid for its stock.
MB = Sales - Cost of Sales / Sales
- OPERATING PROFIT MARGIN (MO): Represents the net profits earned by the company in the value of each sale. These must be taken into account by deducting financial or government charges and determines only the utility of the operation of the company.
- NET PROFIT MARGIN (MN): Determines the percentage that remains on each sale after deducting all expenses including taxes.
- TOTAL ASSET ROTATION (RAT): Indicates the efficiency with which the company can use its assets to generate sales.
RAT = Annual Sales / Total Assets
- YIELD ON INVESTMENT (REI): Determines the total effectiveness of management to produce profits with available assets.
REI = Net Earnings After Taxes / Total Assets
- RETURN ON COMMON CAPITAL (CC): Indicates the return obtained on the book value of stockholders' equity.
CC = Net Earnings After Tax - Preferred Dividends / Stockholders' Equity - Preferred Capital
- EARNINGS PER SHARE (UA): Represents the total earnings obtained for each current ordinary share.
UA = Earnings available for ordinary shares / Number of ordinary shares outstanding
- DIVIDENDS PER SHARE (DA): This represents the amount paid to each shareholder at the end of the period of operations.
DA = Dividends paid / Number of ordinary shares outstanding
Coverage reasons
These ratios evaluate the company's ability to cover certain fixed charges. These are most often related to the fixed charges that result from the company's debts.
- TIMES EARNED INTEREST (VGI): Calculates the company's ability to make contractual interest payments.
VGI = Earnings before interest and taxes / Annual interest expense
- TOTAL COVERAGE OF LIABILITIES (CTP): This ratio considers the company's ability to meet its interest obligations and the ability to repay the principal of the loans or make payments to the sinking funds.
CTP = Earnings before interest and taxes / Interest plus payments to main liability
- TOTAL COVERAGE RATIO (TC): This ratio includes all types of obligations, both fixed and temporary, it determines the company's ability to cover all its financial charges.
CT = Earnings before payments of leases, interests and taxes / Interest + payments to the main liability + payment of leases
At the end of the analysis of the financial reasons, you must have the criteria and sufficient bases to make the decisions that best suit the company, those that help maintain the resources previously obtained and acquire new ones that guarantee future economic benefit, as well. verify and comply with the obligations with third parties in order to reach the primary objective of administrative management, position in the market obtaining wide profit margins with a permanent and solid validity against competitors, granting a degree of satisfaction for all management bodies of this community.
A good financial analysis of the company can provide the security of keeping our company current and with excellent profitability rates.
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Through the following webinar you will be able to continue learning about financial ratios as measurement tools to know the financial situation of an organization, it will surely be useful for you.
Bibliography
- Emery, Douglas R., Finnerty, John D. and Stowe, John D. Fundamentals of Financial Management. Pearson Education, 2000. Gitman, Lawrence J. Principles of Financial Management. Pearson Education, 2003 Horngren, Charles T., Sundem, Gary Ly Elliott, John A. Introduction to Financial Accounting. Pearson Education, 2000. Morales Castro, Arturo and Morales Castro, José Antonio. Quick answers for financiers. Pearson Education, 2002. Van Horne, James C. and Wachowicz, John M. Fundamentals of Financial Management. Pearson Education, 2002.
