CHAPTER-3 REVIEW OF LITERATURE
What is the different type of financials ratios?
Companies use liquidity ratios to measure working capital performance the money available to meet your current, short-term obligations.
Simply put, companies need liquidity to pay their bills. Liquidity ratios measure a company’s capacity to meet its short-term obligations and are a vital indicator of its financial health. Liquidity is different from solvency, which measures a company’s ability to pay all its debts.
There are different forms of liquidity ratio such as:
Current ratio : Current Assets / Current Liabilities
The current ratio measures how a business’s current assets, such as cash, cash equivalents, accounts receivable, and inventories, are used to settle current liabilities such as accounts payable.
Quick ratio (Acid-test ratio): (Current Assets – Inventories – Prepaid Expenses) / Current Liabilities
Also known as the acid-test ratio, the quick ratio measures how a business’s more liquid assets, such as cash, cash equivalents, and accounts receivable can cover current liabilities. This ratio excludes inventories from current assets.
Cash ratio: Cash and cash equivalents / Current Liabilities
The cash ratio measures a business’s ability to use cash and cash equivalent to pay off short-term liabilities. This ratio shows how quickly a company can settle current obligations.
Companies often use short and long-term debt to finance business operations. Leverage ratios measure how much debt a company has. The types of leverage ratio to consider are:
Debt ratio: Total Debt / Total Assets
The debt ratio measures the proportion of debt a company has to its total assets. A high debt ratio indicates that a company is highly leveraged.
Debt to equity ratio: Total Debt / Total Equity
The debt-to-equity ratio measures a company’s debt liability compared to shareholders’ equity. This ratio is important for investors because debt obligations often have a higher priority if a company goes bankrupt.
Interest coverage ratio: EBIT / Interest expenses
Companies generally pay interest on corporate debt. The interest coverage ratio shows if a company’s revenue after operating expenses can cover interest liabilities.
Efficiency ratios show how effectively a company uses working capital to generate sales. A fall in efficiency ratio indicates improved profitability. There are several ways to analyse efficiency ratios:
Asset turnover ratio: Net sales / Average total assets
Companies use assets to generate sales. The asset turnover ratio measures how much net sales are made from average assets.
Inventory turnover: Cost of goods sold / Average value of inventory
For companies in the manufacturing and production industries with high inventory levels, inventory turnover is an important ratio that measures how often inventory is used and replaced for operations.
Days sales in inventory ratio: Value of Inventory / Cost of goods sold x (no. of days in the period)
Holding inventory for too long may not be efficient. The day sales in inventory ratio calculates how long a business holds inventories before they are converted to finished products or sold to customers.
Payables turnover ratio: Cost of Goods sold (or net credit purchases) / Average Accounts Payable
The payables turnover ratio calculates how quickly a business pays its suppliers and creditors.
Days payables outstanding (DPO): (Average Accounts Payable / Cost of Goods Sold) x Number of Days in Accounting Period (or year)
This ratio shows how many days it takes a company to pay off suppliers and vendors. A lower day’s payables outstanding implies that a business is letting go of cash too quickly and may not be taking advantage of longer credit terms. On the other hand, when the DPO is too high, it means a company delays paying its suppliers, which can lead to disputes.
Receivables turnover ratio: Net credit sales / Average accounts receivable
Accounts receivables are credit sales made to customers. It is important that companies can readily convert account receivables to cash. Slow paying customers reduce a business’s ability to generate cash from their accounts receivable.
The receivables turnover ratio helps companies measure how quickly they turn customers’ invoices into cash. A high receivables turnover ratio shows that a company quickly generates cash from accounts receivables.
A business’s profit is calculated as net sales less expenses. Profitability ratios measure how a company generates profits using available resources over a given period. Higher ratio results are often more favourable, but these ratios provide much more information when compared to results of similar companies, the company’s own historical performance, or the industry average. Some of the most common profitability ratios are:
Gross margin: Gross profit / Net sales
The gross margin ratio measures how much profit a business makes after the cost of goods and services compared to net sales.
Operating margin: Operating income / Net sales
The operating margin measures how much profit a company generates from net sales after accounting for the cost of goods sold and operating expenses.
Return on assets (ROA): Net income / Total assets
Companies use the return on assets ratio to determine how much profits they generate from total assets or resources, including current and non-current assets.
Return on equity (ROE): Net income / Total equity
Shareholders’ equity is capital investments. The return on equity measures how much profit a business generates from shareholders’ equity.
Market Value ratios
Market value ratios are used to measure how valuable a company is. These ratios are usually used by external stakeholders such as investors or market analysts but can also be used by internal management to monitor value per company share.
Earnings per share ratio (EPS): (Net Income – Preferred Dividends) / End-of-Period Common Shares Outstanding
The earnings per share ratio, also known as EPS, shows how much profit is attributable to each company share.
Price earnings ratio (P/E): Share price / Earnings per share
The PE ratio is a key investor ratio that measures how valuable a company is relative to its book value earnings per share.
Book value per share ratio: (Total Equity – Preferred Equity) / Total shares outstanding
A company’s common equity is what common shareholders own after all liabilities and preference shares have been settled from total assets.The book value per share measures the value per share for common equity owners based on the balance sheet value of assets less liabilities and preference shares.
Dividend yield ratio: Dividend per share / Share price
The dividend yield ratio measures the value of a company’s dividend per share compared to the market share price.
When companies pay out dividends to shareholders, the value of dividends received for each share owned is known as the dividend per share. Shareholders and analysts compare the dividend per share to the company’s share price using the dividend yield ratio.
What is the impact of the profitability of microfinance institutions?
Microfinance profitability are measured by efficiency and productivity, financing structure and portfolio quality ratios. Profitability is measured by return on equity ratio, return on assets ratio, and profit margin ratio.
Sustainability is measured by operational self-sufficiency ratio.
Return on equity ratio
The net income of the firm is divided by total shareholder equity to arrive at the ROE ratio, which is then reported as a percentage. If the equity and net income are both positive in value, the ratio can be determined with accuracy. Net income / Common Shareholder Equity is the formula for return on equity.
Return on assets ratio
Divide a company’s profits after tax by its total assets to get the return on total assets ratio. This profitability indicator assists you in determining how your firm makes profits and how you compare to rivals.
Profit margin ratio
The profit margin is calculated by dividing a company’s profit (sales minus all costs) by its revenue. The profit margin ratio compares profit to sales and indicates how well the firm manages its finances in general. It is usually given as a percentage.
How financial performance affects financial stability?
Performance is achieving your goals by using the resources at your disposal in the best possible way. Like a chess player who has a limited number of pieces to win a game, the entrepreneur must achieve his goals with limited resources. These resources are human, material, immaterial and financial.
Financial performance is therefore the achievement of fixed results over a period of time, using your company’s finances in an optimal way. On the one hand, you have financial goals. These are generally objectives related to sales, margins, or profitability. To achieve this goal, you will use a leveraged resource: finance.
These are the financial resources available to your business to generate business. These finances are mainly:
You can also benefit from aid, subsidies, or crowdfunding for example. As always, money isn’t everything. Your teams, your ability to innovate, the satisfaction of your customers and your brand image will also play an important role in the development of your business.
But money is the sinews of war. Used in the best way, it will allow you to finance the best investments, to advance the funds necessary to launch more important missions or productions, to boost your visibility and your reputation thanks to marketing campaigns, and many other actions. profitable for your business.
By managing your company’s financial performance, you also ensure a competitive advantage. Because too many entrepreneurs neglect financial management. They are missing out on opportunities and leverage effects that would allow them to go faster. Let’s now see together how to set up this performance management.
The best method in our opinion is to proceed step by step. First, set consistent and realistic financial goals. Then, set up performance measurement indicators, presented in a dashboard. Finally, by analysing these indicators and the gaps between objectives and reality, you will be able to make informed decisions, based on the best information.
Why ratios are used to measure financial performance?
Financial ratios are used to assess a company’s profitability, financial structure, cash flow and activity. These tools are used in particular in the evaluation phase
carried out before buying a company or to compare its performance with other companies in the same sector.
Given the multitude of existing financial ratios, it is necessary to select the most relevant ones according to your company and your activity. Once calculated, the financial ratios provide easy-to-analyse information that will easily detect the strengths and weaknesses of the company.
Financial ratios are an excellent tool to evaluate your company’s performance and identify potential issues. Certain aspects, such as your company’s profitability, solvency, efficiency, and indebtedness, may be measured using ratios.