Financial Ratio Analysis: Understanding Key Performance Indicators
Financial Ratio Analysis
Financial ratios are used to evaluate a company’s performance across several key areas:
- Liquidity: Measures the company’s ability to meet its short-term obligations.
- Management (Activity): Measures the efficiency of asset utilization and turnover.
- Debt (Leverage): Relates resources and commitments, indicating the level of financial risk.
- Profitability: Measures the company’s ability to generate wealth.
Liquidity Ratios
(1) Overall Liquidity:
A ratio of 2.72 indicates that current assets are 2.72 times greater than current liabilities. This means the firm has UM 2.72 to pay for every UM of debt. A higher ratio generally indicates a greater ability to pay debts.
(2) Acid Ratio: Provides a more stringent measure of short-term solvency.
(3) Defensive Interval: Indicates the ability of the company to operate using only its most liquid assets. A value of 21.56% suggests the company can operate for a period without relying on sales revenue.
(4) Working Capital: Represents the financial resources available to meet short-term obligations.
(5 & 6) Accounts Receivable Turnover (Average Collection Period): An accounts receivable turnover of 5.89 indicates that accounts receivable circulate approximately every 61 days. This is the average time it takes for receivables to be converted into cash. The average collection period can be calculated by dividing 360 days by the accounts receivable turnover.
Management (Activity) Ratios
(7) Portfolio Turnover:
A portfolio turnover of 5.63 times, or 63.97 days, indicates how quickly a company collects its receivables. A high turnover rate is generally desirable as it suggests an effective credit policy and prevents funds from being tied up in accounts receivable. An optimal turnover rate is typically between 6 and 12 times per year (30-60 day recovery period).
(8 & 9) Inventory Turnover: This means that inventories are sold approximately every 172 days, or 2.09 times per year. A higher turnover indicates efficient inventory management and faster recovery of invested capital.
(10) Payment Period to Suppliers: Ideally, a slower payment rate (e.g., 1, 2, or 4 times a year) is desirable, as it indicates that the company is maximizing the credit offered by its suppliers.
(12) Total Asset Turnover: A ratio of 1.23 indicates that the company generates sales of 1.23 times the value of its total assets. This ratio measures how effectively assets are used to generate sales.
Debt (Leverage) Ratios
(15) Debt Ratio:
A debt ratio of 44.77% indicates that 44.77% of the company’s assets are financed by creditors. If the company were to liquidate its assets, creditors would be paid first, leaving 55.23% of the asset value for the owners.
Profitability Ratios
(18) Return on Assets (ROA):
A ROA of 3.25% means that for every UM of assets, the company generates a profit of 3.25%. This measures the company’s ability to generate profit from its assets.
(19) Return on Investment (ROI): A ROI of 1.79% indicates that every UM invested in assets generates a return of 1.79%. Higher ROI values indicate greater sales and profitability.
(20 & 21) Profit on Assets or Sales: The company generates a profit of 12.30% for each MU invested in assets or per unit sold.
(22) Earnings per Share (EPS): This ratio indicates that the value per common share was UM 0.7616.
(23) Gross Profit Margin: Indicates the profit earned on sales after deducting the cost of goods sold. A larger gross margin indicates efficient operations and effective pricing strategies.
(24) Net Profit Margin: A net profit margin of 1.46% indicates that for each UM of sales, the company made a profit of 1.46% after all expenses, including taxes. This ratio assesses whether the operational effort is generating adequate returns for the entrepreneur.