Financial ratios and their application in business
The sustainability of any business depends on effective planning and optimal financial management. The analysis of financial ratios helps to improve the understanding of financial results and trends over time, providing key indicators of the performance of the organization that provide a much-needed global vision. Through its study, it will be possible to identify the main strengths and weaknesses, from which any strategic development must be based and on which all initiatives must be based. The financial ratios also fulfill another function, which is to allow benchmarking , that is, to facilitate the comparison of the results themselves with those achieved by the competitors and to promote the objective assessment of the effectiveness of the management carried out by the doors.
What is a ratio or financial indicator? When before a fight, the announcer announces a boxer indicating the total amount of combats, victories and knock-outs that he has had in his career, he makes a brief analysis of the athlete's productivity.
A financial ratio works in a similar way: it takes a large amount of information from different areas of a company and relates it in a simple numerical quotient, ideal to synthetically describe the productivity with which the firm generates income from certain assets and costs.
How useful are the ratios for an entrepreneur? The ratios have two very useful basic applications. In the first instance, they can be used to analyze the current performance of the company and compare it with historical data. This not only helps validate the original business plan, but also allows faults to be detected and corrected on time.
Additionally, the ratios can be used to make quick comparisons between companies. In the context of small or medium enterprises, it is difficult to access reliable accounting information from competitors. But, the comparative use of the ratios is perfectly possible and useful in the case of branches or different business units. What types of ratios are there? Large commercial companies with numerous subsidiaries, stock market participation and capital of diverse origin, can use literally hundreds of indicators. To an SME, however, a dozen ratios estimated with good judgment can reach you for an efficient analysis.
Profitability and sustainability ratios
· Sales growth: percentage of increase or decrease in sales between two periods of time.
· Dependence on sources of income: helps to assess the nature and risk of the sources of income of the organization, not only in relation to sales, but also other sources of income such as contributions or grants.
· Operational self-sufficiency: measures the degree to which the expenses of the organization are covered by its main activity and, therefore, its independence from other sources of income.
· Gross profit: measures the profit obtained from sales without taking into account the indirect costs.
· Net profit margin: amount of money obtained for each Euro that is sold (measures the capacity to cover all operating costs, including indirect costs).
· Percentage of indirect costs to sales.
· Return on assets: measures the ability to convert assets into benefits.
Operational efficiency ratios
· Operating expenses ratio: compares expenses with income.
· Rotation of collection accounts: informs about the number of times that the rotation of collection accounts occurs during the year.
· Rotation of days to account: compares the payment habits of the main customers with the collection policies of the organization.
· Inventory Rotation: These financial ratios measure the number of times inventory turns into sales during the year or the number of days it takes to sell the inventory.
· Days in the inventory: this is a good indicator of the efficiency of production and sales, when reporting on the time that the products are unemployed. A high proportion indicates that the inventory is being sold quickly and that it is stored little, while lower figures suggest excess inventory, obsolete inventories or problems of commercial performance. Rotation of fixed assets or rotation of total assets indicates the efficiency of the business to generate sales for each dollar invested in assets.
· Current reason: this type of financial ratios measure the capacity of the company to comply with short-term obligations with short-term assets; a useful indicator of cash flow in the near future.
· Rapid ratio: this is one of the most stringent tests of liquidity, which indicates whether a company has sufficient assets in the short term (without the sale of inventory) to cover its immediate liabilities.
· Working capital: measures the amount of capital invested in resources that are subject to rapid turnover.
· Adequacy of resources: determines the number of months that could continue to operate without receiving new funds.
· Debt to equity: compares the capital invested by the owners or providers of funds (including donations) with the funds provided by the lenders.
· Interest coverage: measures the ability of the business to comply with its obligations to pay interest on its own income.