These are useful tools that show the performance of a firm and firm’s financial situation. It is calculated from financial statements. The ratios help to analyze the trend and make comparison of a firm to other firms. (Gapenski, 1994) The four financial ratios are: Liquidity ratios, asset turnover ratios, financial leverage ratios and profitability ratios. What financial ratios tell about a firm Liquidity ratios This ratio tells about the ability of a firm to cater for its financial obligations in the short term.
The information about obligation is important to those offering the firm with short term loans in order to determine the firm’s ability to pay back the loan as quickly as possible. Asset turnover ratios It tells about how a firm uses or manages its assets efficiently. Receivable turnover is the duration in which sales made through credit stays in the accounts receivable waiting to be collected. Inventory turnover is the mean inventory divided by cost of goods for one year (Gapenski, 1994) Financial leverage ratios This ratio shows how the firm uses its long-term loan.
It tells about the level of solvency of a firm in the long run. It consists of debt ratio which is the amount of total debts divide by total assets and debt to equity ratio is the amount of total debts divide by total equity. Profitability ratios This ratio is used to measure the success of a firm basing on how it generates profit. It shows the gross profit generated from sales and the effective use of assets to generate profits.
Shareholders use it to get the profit from the money invested on the firms stock. Why it’s important to understand what these ratios mean to a bank
The bank will be able to ensure that it maintains high cash reserves and expenses are not increasing and also helps a bank to decide which customer need to have longer credit in case of a large order. The bank will be able to borrow more frequently when its sales are increasing because more money will be needed to finance its sales. The ratios will help make comparison of various aspects of banks performance in order to ensure that the bank is performing well and is not operating at loss and also ensure that is not accumulating too much debt. (H’erman, Raymond, 2000) Why it is important to understand what these ratios mean to an investor
These ratios will help an investor know the stability of the business by looking at the balance sheet which shows whether the business is operating under profit or loss. The business that makes profit is stable. The ratios also will help to examine the company’s performance in order to know whether it is risky to invest in it. If the company has high risk, it should give high returns. An investor should compare the company to the industry as a whole in order to know where there is need to make adjustments in order to increase the out put of the company (Hudson, Colley, 2000)
Financial ratios will help the investor to get neutral and useful information about the company because in case of numerical figures provided, they cannot be altered thereby providing true information which is not distorted.
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