INTRODUCTION

Financial ratios are one of the most commonly used analytical tools in business world today. The ratios involve comparison of various figures from the firm’s financial statements that help in identifying the firm’s financial position.  Information from these ratios is used in making essential managerial decisions in matters relating to the company. Users of the ratios include shareholders, directors, suppliers and debtors just to mention a few. The most prevalent financial ratios include the profitability ratios, turnover ratios and the leverage or the liquidity ratios.  It is however imperative to note that the reliability on the information from financial ratio is dependent on the ability to interpret rather than the calculations. The ratios serve as red flags, indicators or clues on the performance of the firm thus proving important for the management. The report will have an analysis of the three most common financial ratios.

1. Turn over ratios

As aforementioned, turnover ratio is one of the most used financial ratios. It refers to the measure of fund’s trading activity. In essence, turn over ratios involves dividing the firm’s annual income statement by the average balance of an asset or group of assets for a period of one year.  Example of turn over ratios includes inventory turnover ratio and the accounts receivable turnover ratio.

Inventory turnover ratio: this is a financial ratio that is concerned in showing how many times a company’s inventory is sold and replaced over a given period.

It can be calculated as; (i) inventory turnover=sales/inventory. Or

(ii) Inventory turnover = costs of goods sold/ average inventory.

It should however be noted that, the second formula, that involves cost of goods sold, is frequently used as compared to the other formula. After calculating the ratio, it should be compared against the industry averages. A low turnover is an indication of poor sales and hence excess inventory. On the other hand, a high, inventory turnover ratio indicates strong sales or ineffective buying. It is imperative for firms to ensure a balanced rate of return since even a high rate of return is also not healthy. Such high rates of return represent an investment whose return on investment is zero. This is a very dangerous situation for the business especially if there is a downward trend in the firm’s products prices. Nevertheless, a higher inventory turnover ratio is better since it enables a firm to have enough supply that meets the customer’s needs.

Accounts receivables turnover ratio:  this is another important ratio used by firms in quantifying its effectiveness in extending credit and how it collects debts arising from these credit sales. It is a ratio that helps the firm analyzes how efficiently it uses its assets. The ratio refers to the number of times, annually, that a firm collects its average accounts receivable. It is calculated by dividing the net value of credit sales during a given period, mostly one year, by the average accounts receivables during the same period. It can also be calculated by adding the values of accounts receivable at the beginning of the desired period to their value at the end of the period and then dividing the figure by two.

Accounts receivable turnover =Net credit sales/average accounts receivable

It should be noted that a high turnover ratio indicates a combination of a conservative credit policy and an aggressive debt collection department. On the other hand, a low accounts receivable ratio is an indication of low quality customers as well as poor credit management policy in the firm. It is also worth noting that this would also be an indication of excessive amount of bad debt.

Profitability ratios

The primary objective of ay business organization is profit maximization. This implies that firms will always be in efforts to maximize their profits. As a result, profitability ratios are important ratios that help in making major management decisions. These are ratios that are used to assess the business’s ability to generate earnings as compared to its expenses and other incurred costs during a given period.  A higher ratio compared to others in the industry or the same ratio that is higher from the previous is an indication tat he firm is doing well. In most cases, profitability ratios focus on a firm’s return on investment, in inventory and other assets. In essence, profitability ratios are used to show how well organizations can achieve profits from their daily operations.

Return on equity (ROE):  This is a form of profitability ratio that is concerned with the firm’s ability to generate profits from its shareholders investment in the organization. In essence, it is concerned in revealing the amount of profit a company generates with the money invested by the shareholders. Return on equity ratio is also an indicator of how effective the management is at using equity financing to fund the operations and growth of the firm. It is calculated by dividing the firm’s net income by the shareholder’s equity (mostly common stocks).

ROE= Net income/shareholders equity

A high return on equity ratio is an indication that the firm is using funds from its investors effectively while lower ratios is an indication of mismanagement of the owner’s equity. It should however be noted that the ratio can only be effective if used to compare firms in the same industry.

Return on assets (ROA): It is also referred to as return on total asset ratio and measures the net income produced by total assets during a given period. In essence, return on assets ratio is concerned with understanding how efficiently and effectively a firm can manage its assets to produce profits during a given period. It is sim

 
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