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Financial Ratio Analysis Definitions and Descriptions

Written by Samuel Muriithi for Gaebler Ventures

Financial ratio analysis involves the computation and comparison of ratios which are drawn from the information contained in a business' financial statements. These different financial ratios are helpful in making assessments about a business' overall financial soundness, the effectiveness of its operations, and its attractiveness as an investment consideration.

In financial ratio analysis four categories of financial ratios are used i.e. profitability, liquidity, investor and efficiency ratios. Each of these categories features a number of related ratios.
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  • Profitability financial ratios make use of margin analysis and they are meant to display the return on sales and the capital employed.
    • The gross profit margin is calculated through the formula (gross profit/revenue) X100. It is used to indicate how well a business controls its production costs or the margins it enjoys on the products it buys or sells.
    • The operating profit margin is computed as (operating profit/revenue) X100. This financial ratio assumes a constant gross profit. It shows how well a business manages its operating costs and other overhead costs.
    • Return on capital employed is obtained as (EBIT/total assets) X100 or (EBIT/total assets - liabilities) X100. The ratio is used to illustrate the return on resources used before these are distributed.
  • Liquidity ratios' use in financial ratio analysis is basically to show a business' solvency or short term financial health.
    • Current ratio is determined as current assets/current liabilities. It is used to determine if a business can settle its debts in a year using the assets it hopes to convert into cash within the same timeframe.
    • Quick ratio or acid test is computed as (current assets - inventory)/current liabilities. It is used to determine whether the current assets that can be quickly converted into cash are sufficient to settle current liabilities.
  • Investor ratios are those financial ratios that are used to make an assessment of a given business in terms of being fit for investment.
    • The earnings per share ratio is calculated via the formula total earnings/number of shares outstanding. It provides a measure of the overall profit that each share has generated in a given period of time.
    • The price earnings ratio is computed as market price of share/earnings per share. It is an indication of how well a business is valued or rated in the market.
  • Efficiency ratios are used to determine how efficiently a business is using the resources that have been invested in working capital and fixed assets.
    • Sales/Capital Employed as a financial analysis ratio is computed exactly as this formula appears. It is used to show how well the assets are being used to achieve sales.
    • Stock turnover is computed as cost of sales/average stock value. The business owner can use this formula to ascertain whether or not too much money is tied up in stocks/inventory.
  • Return on investment as a financial ratio indicates a business' profitability and how well the business is using its capital to make profits. The business owner can with this ratio know whether or not a certain investment recouped its own cost or not. To compute it the required formula is ROI = net profit/investment. Investment in this case is the sum of the owner's investment, and the short and long term debts.

Samuel Muriithi is a business owner in Nairobi, Kenya. He has extensive international business experience in the United States and India.

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