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TYPES OF FINANCIAL RATIOS

1. Growth Potential Ratios

2. Profitability Ratios,

3. Liquidity Ratio,

4. Activity or Turnover or Efficiency Ratios and

5. Gearing or Capital Structure Ratio.

Short-Term Solvency and Liquidity Ratios

This ratios measure the ability of a business to meet its short-term financial obligations. These firms started the consistent use of ratios to Analyze company financial position. The following ratios are useful in the measurement Of liquidity and short term solvency

 Current ratio

 Acid Test Ratio

 Cash Ratio

 THE CURRENT RATIO

Current ratio is a form of comparing assets which will become liquid in approximately Twelve months with liabilities which will be due for payment in the same period. It shows a much higher ratio by over-valuing assets as a result of bad ones, Obviously, a Ratio in excess of 1 should be expected, but what is ‘comfortable’ varies between Different types of businesses.

 THE ACID TEST RATIO

It measures the extent to which immediately realizable assets cover the current liabilities And this quick ratio will convert very quickly into cash. This will normally mean cash and Debtors or current assets less stock-in-trade. Companies are not able to convert all their Current assets into cash very quickly. For example, manufacturing companies, where Stock turnover is slow, most stocks are not very liquid assets, because the cash cycle is so Long. Therefore, the formula is as thus The acid test ratio, is Current assets – inventory. This ratio should ideally be at least 1 for companies with a slow stock turnover. For Companies with a fast stock turnover, a quick ratio can be less than 1 without suggesting That the company is in cash flow difficulties.

Activity Ratio

This ratio is used to measure the efficiency of management in using the assets employed In carrying on its day to day activities and utilizes the assets under its control. These Ratios are also called Turnover Ratio, Efficiency ratios and Assets management ratios. Therefore, the following are the component of Activities ratios;

 Inventory Turnover

 Payable Payment Period

 Receivables’ Turnover Ratio

INVENTORY TURNOVER

This inventory turnover relates the cost of sales to the average inventory .The inventory Turnover ratios gives the number of times the average inventory holding of this company Could be utilized in meeting the supply of its products for sales. This ratio is significant to Management and also shows how good management of inventory is. Therefore, the ratio Is used to assess inventory utilization but it is well to remember that the ratio may be Distorted by industry characterized e.g. a supermarket is likely to have a very high stock Turnover while a jeweler may have a very low turnover.

INVENTORY HOLDING PERIOD

This shows the rate at which customers are planning for credit sales. It is a measure for Efficiency of credit control. The higher the ratio, the more liquid the business increases. The question is silent on cash or credit sales, the sales figure should be considered.

PAYABLE PAYMENT PERIOD

This is the ratio of creditor to credit purchases. The ratio shows how quickly creditors are Paid. This means the velocity (the no of times) per period of time at which average stock Is sold. The lower the ratio, the better for the creditors who only have to wait for a short Period to get paid for the goods supplied or service rendered and it is calculated as Follows;

Payable payment period = Trade payable x 365 Credit purchases 1

PAYABLE PAYMENT PERIOD

This is the ratio of creditor to credit purchases. The ratio shows how quickly creditors are Paid. This means the velocity (the no of times) per period of time at which average stock Is sold. The lower the ratio, the better for the creditors who only have to wait for a short Period to get paid for the goods supplied or service rendered and it is calculated as Follows;

 Payable payment period = Trade payable x 365 Credit purchases

RECEIVABLES’ TURNOVER RATIO

Receivables turnover ratio measure the effectiveness of debt collection functions and it Connotes that the company is effective and efficient in cash collection. By comparison Over a number of periods, management can see whether its credit policy is working or Whether debtors are showing up their payments. Also, if there was a credit squeeze in Country, this may make debtors avoid paying for as long as possible.

THE AVERAGE RECEIVABLE PERIOD

 This indicates a level of inefficiency in debtors’ management. Management should Intensify efforts in addressing this shortcoming. It is expressed as the average period for Which credit is allowed to the customer and it is calculated thus;

 Average receivable x 365days Credit sales

Profitability Ratios

Profitability is the end-product of the policies and decision taken by a firm and it is single Most important measure of success because it serves as the overall operative performance Of a business. This ratio measures the overall performance and effectiveness of a firm. Profitability ratios are used to discover how efficiently and effectively assets have Contributed to the profit of the firm because of single most important measure of success. Therefore, the following are the measures of profitability ratios as thus;

 Return on Capital Employed

 Gross Profit Margin

 Net Profit Margin

 Total Asset Turnover

 Individual Asset Turnover