analysis of financial ratios - types of financial ratios

Analysis of Financial Ratios to Access Bank Loans

Analysis of financial ratios is important to businesses that keep adequate financial records. Even if you think that you don’t need them for your business, maintain them for financial health evaluation.

Analysis of financial ratios is important to businesses that keep adequate financial records. All businesses, no matter how small, are required to keep financial records. When records are appropriately kept, business owners and managers can perform financial ratios analysis to evaluate business performance.

Analysis of financial ratios is not required internally only but can be required externally, especially, when accessing bank loans.

Today, we are going to look at the analysis of financial ratios and how they can affect access to bank loans.

What are Financial Ratios?

Ratio is the quantitative relationship between two items or numbers. It may also be defined as how many of an item is contained in another item. For example, the ratio of A and B, written as [A: B] is the relationship between A and B.

Similarly, financial ratios mean the quantitative relationship between two financial items in a financial statement. While discussing what is financial analysis, we identified three key elements and three main sources of financial data.

From these financial sources, we identify key elements that describe business performance within a given period. These elements can be liquidity, profitability, and solvency for small businesses. They can also extend to management efficiency and valuation and growth ratios for large organizations.

Therefore, financial ratios are a quantitative comparison between two financial items in a financial statement to determine a company’s performance. There are numerous benefits of financial ratios analysis, some include:

Benefits of analysis of financial ratios

  1. One of the benefits of analysis of financial ratios is for industry comparison. With an established industry average, we can compare the performance of different businesses in the same industry. Financial ratios make this comparison easy and effective, especially, when one wants to make urgent financial decisions. Financial market investors usually evaluate ratios to determine the best company to invest in. A collection of financial ratios over time will form a trend line that can be used to draw a market inference. A small business owner can also compare the performance of his/her business with others in the same line. This will enable him/her to know if the business is doing well.
  2. One major importance of financial ratio is to determine the operational effectiveness and efficiency of the business. Using financial ratio estimates, you will understand how business resources are being managed. Depending on the ratios being analyzed, business efficiency will be revealed when ratios are analyzed.
  3. Analysis of financial ratios can be helpful when evaluating business goals. Businesses set SMART goals; ratios could be used as a metric to determine goal accomplishment.
  4. Another hidden benefit is that financial ratios can be used as a performance evaluation to access bank loans. Banks can use financial ratios to evaluate a firm’s performance to advance business loans. There are reasons for this which we will explain below.

Disadvantages of analysis of financial ratios

Though financial ratios can be useful in many areas, it has various disadvantages. These disadvantages place a hitch on the use of financial ratios to evaluate business performance. Some of the disadvantages are:

  1. The trend of financial ratios can be distorted in periods of inflation, making the data unreliable.
  2. If firms decide to manipulate their financial data, financial ratios will become unreliable. Because they do not reflect the actual performance of the business.

Financial Ratios and Banks’ Bad Debt Management

One of the major reasons financial institutions exist is to advance loans and credit to businesses and individuals. But most times, banks fail to fulfill this obligation, especially, Nigerian Banks. There are reasons behind this, paramount among them is the incidence of bad debts.

In their study, on the incidence of bad loans, Alawiye-Adams and Afolabi (2013)[1] identified three significant causes:

  1. the unwillingness of banks’ customers to provide adequate information
  2. failure to carry out a detailed assessment of the customers’ loan requests, and
  3. inadequate securitization in bank lending.

This finding agrees with Dandy (1975) that enumerates factors that may cause bad and doubtful debt to arise. These factors include excessive lending, bad management of borrowers’ bank account, incomplete knowledge of customers’ activities, bad judgment. Others include over-trading, over-reliance on-trade customers, optimistic balance sheet, misrepresentation, and dishonesty of customers.

According to Fagbure (2017)[2], Nigerian banks are overburdened by the incidence of non-performing loans to the tune of 15trillion naira. This huge debt has made it difficult for small businesses to access a loan in most Nigerian banks.

Therefore, to reduce the incidence of bad debts, there is a need for effective loan management for banks. One principle of loan management as opined by Nwankwo (1991)[3] is the principle of analysis of financial ratios. This involves the analysis of the financial statement of customers and appraising the financial health of the business.

For purpose of comparison, the audited figures are expressed as ratios computed from audited figures of two consolidated business years. The analysis of financial ratios of a business requesting a loan will help to determine its creditworthiness. It will also help to know its ability to repay the loan.

Moreover, financial ratios help a banker to assess the degree of risk being taken. Emphasis is usually placed on earning capacity and the operating efficiency of the business.

Mather (1979) grouped financial ratios into five categories as follows:

  1. Liquidity ratios, which provide a measure of a business’s ability to meet its short-term obligation.
  2. Leverage ratios, which are measures of the extent to which a firm’s operations are financed with debt capacity.
  3. Efficiency ratios, which are used to measure the capabilities of the management to utilize the firm’s assets.
  4. Profitably ratios, which indicate the overall profitability of the business enterprise.
  5. Equity-related ratios, which are of primary concern to common stockholders.

Types of Financial Ratios

As stated above, there are five (5) main categories or types of financial ratios. Each of these financial ratio types has a group of ratios that can be computed. Each of these ratios represents different performance indicators. And is not required by all kinds of businesses. Let us briefly discuss each type of financial ratio.

Liquidity ratios

Liquidity ratios measure the short-term solvency of a business venture. It is used to ascertain the ability of a business to meet its short-term obligations such as loans, etc. With liquidity ratios, we can know the extent to which claims of creditors are covered by assets. Especially, assets that are expected to be converted to cash within the maturity period of the claims. There are three common types of liquidity ratios that can be used, namely

  1. Current ratio: which evaluates the capacity of a business to meet its short-term obligations with its current assets.
  2. Quick ratio: which measures the ability of a business to meet its short-term obligations with its most liquid assets. It is also called the acid-test ratio.
  3. Cash ratio: which measures the ability of a business to meet short-term obligations with cash and cash equivalent items. Cash equivalents can be marketable securities such as treasury bills, short-term bonds, etc.

Under adverse conditions, stocks may not have sufficient liquidity therefore the quick ratio may be more reliable than the current ratio. The quick ratio measures the firm’s ability to pay off current liabilities without relying on the sale of stock. An important factor to watch closely when using a quick ratio is the underlying quality of debtors.

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Analysis of financial ratios (Credit: Photo by Lukas on Pexels.com)

Leverage ratios

The leverage ratios evaluate the owner’s equity in relation to business creditors. It reveals how much debt a business is using to finance its operations. It tells how much a business relies on debt or how much business capital comes from debt. The following are the leverage ratios you can evaluate.

  1. Debt ratio: measures the number of a business’s assets financed by debt. It shows the level of business obligations to others.
  2. Equity ratio: measures the owner’s contribution to total assets.
  3. Debt-equity ratio: measure the overall capital structure of a business by revealing how much the owner’s contribution covers business liability.
  4. Interest coverage ratio: measures a business’s ability to cover its interest payments on loan within a specified time using its profits.

The debt-equity ratio is the most important of the leverage ratios. It measures total claim on a business of all forms of creditors in relation to owners’ equity. All other debt ratios are complementary to this one and are designed to measure the appropriateness of the capital structure.

Efficiency ratios

Efficiency ratios measure how efficiently a company manages its business resources. They are indicators of managerial efficiency in the use of the firms’ assets. Efficiency ratios are very useful in judging the performance of a firm. They help in explaining any improvement or decline in the solvency of a business. They may also help to explain underlying changes in profitability. Some of the ratios include:

group of people sitting indoors
Efficient Management (Credit: Photo by fauxels on Pexels.com)
  1. Fixed assets turnover: which measures how efficient a business generates sales with its fixed assets.
  2. Operating cycle: which measures the number of days it takes a business to purchase inventory, sell them and collect cash. The lesser the number of days, the more efficient the business.
  3. Inventory turnover: which measures the number of times a business inventory is sold and replaced.
  4. Days sales outstanding: which measures the number of days it takes a business to recover cash from sales. It is also called the collection period or receivable turnover in days.
  5. Days inventory outstanding: which measures the number of days it takes to purchase inventory and sell them. It is also called inventory turnover in days or days sales in inventory. It answers how long an inventory stays in the shop or warehouse before it is sold off.
  6. Days payable outstanding: which measure how long it takes for a business to pay up its vendors for goods purchased.
  7. Receivable turnover: which measures the number of times a business sells on credit to customers and collects cash within one year.
  8. Cash conversion cycle: measures how long it takes for a business to purchase inventory, sell them, collect cash and make payments to suppliers.

Profitability ratios

The profitability ratios are important to the banker, the creditors, and the shareholders of a business. This is because if sufficient profit is not made, it would be difficult to meet financial obligations. It will be difficult to pay operating expenses, interest charges on loans, and dividends to shareholders. Profitability ratios measure the ability of a business to generate income from operations using its business resources.

  1. Gross profit margin: measures how much gross profit is generated from overall sales or turnover.
  2. Operating profit margin: measure the profitability of a business from sales after covering operating expenses. It is also called return on sales or net profit margin.
  3. Return on assets: measures how efficient management uses its assets to generate income.
  4. Return on equity: measures how efficient a business is using its equity or capital to generate income.
person holding white and blue box
Financial Ratios (Credit: Photo by Artem Podrez on Pexels.com)

Equity or market valuation ratios

These are ratios used to evaluate the worth of a company in the financial market. They measure the values and earnings of a firm’s common stock. Some of them are:

  1. Earnings per share (EPS): is used to measure the amount of income earned for each outstanding share.
  2. The Price-earnings ratio: is used to evaluate the relationship between a company’s share price and its EPS.
  3. Book value per share: is used to evaluate the value of each share of a company based on the company’s available shareholders’ equity.
  4. Dividend yield ratio: is used to calculate the amount of dividend accredited to shareholders based on the market value per share.
  5. Dividend payout ratio: is used to derive the portion of net income that should be distributed to shareholders.

Financial Ratios Formulas for the Analysis of Financial Ratios

The analysis of financial ratios requires the evaluation of each of the ratio types discussed above. A small business may not necessarily require all the above ratios, but a few that evaluates its performance. For example, a small business does not need any of the market valuation ratios.

Let us bring to your knowledge the financial ratios formulas you will need to effectively perform analysis of financial ratios.

Liquidity financial ratios formulas

  1. Current ratio:
Current ratio = \frac {current Assets} {current Liabilities}
  • Quick ratio:
quick Ratio=\frac{current Assets-inventory}{current Liabilities}
  • Cash ratio:
cash Ratio=\frac{cash+cash Equivalents}{current Liabilities}

Leverage financial ratios formulas

  1. Debt ratio:
debt Ratio=\frac{(total Liabilities)}{(total Assets)}=1-equity Ratio
  • Equity ratio:
equity Ratio=\frac{total Equity}{total Assets}=1-debt Ratio
  • Debt-equity ratio:
debt-equity Ratio=\frac{total Liabilities}{owners Equity}
  • Interest coverage ratio:
interest Coverage Ratio=
\frac{operating Income Or EBIT or PBIT}{interest Expenses}

Where: EBIT means Earnings Before Interest and Taxes

            PBIT means Profit Before Interest and Taxes.

Both are the same, it depends on the terms you are using in your income statement.

Efficiency financial ratios formulas

  • Fixed assets turnover:
fixed asset turnover ratio=\frac{net Sales}{average Fixed Assets}
  • Operating cycle:
operating Cycle (in days) = DIO+DSO
=365×\frac{average Inventory+average Account Receivables}{cost Of Goods Sold (COGS)}
  • Inventory turnover:
inventory turnover=\frac{Cost of Sales (COGS)}{average Inventory}
  • Days sales outstanding (DSO):
DSO (in days)=\frac{365 days}{receivable turnover}
  • Days inventory outstanding (DIO):
DIO (in days)=\frac{365 days}{inventory Turnover}
  • Days payable outstanding (DPO):

Where: APT means Accounts Payable Turnover

APT measures the number of times a business entity pays its account payable within one year period. To calculate APT, use the formula:

APT=\frac{Net credit purchases}{average accounts payable}
  • Receivable turnover:
Receivable turnover=\frac{net Credit Sales}{average Accounts Receivable}
  • Cash conversion cycle:
cash Conversion Cycle (CCC) = DSO+DIO-DPO 
=365×\frac{avg.inventory+avg.acct receivables-avg.acct payable}{cost of goods sold (COGS)}

Profitability financial ratios formulas

  1. Gross profit margin:
gross margin=\frac{(gross profit)}{(net sales)}
  • Operating profit margin:
operating margin=\frac{operating Income / net Profit}{net Sales}
  • Return on assets:
return on assets (ROA)=\frac{net profit}{average Total Assets}
  • Return on equity:
return on equity (ROE)=\frac{net profit}{owners' equity}

Conclusion

The analysis of financial ratios is relevant though overwhelming. Managers should compute important ratios from time to time to ascertain the health of their business.

Even if you think that you don’t need them for your business, maintain them for financial health evaluation. You may not tell; your business may need extra funding to expand your business tomorrow. Analysis of financial ratios will help investors make quick decisions on your business. Do not stop here, visit your financial records, extract relevant data and compute relevant financial ratios for your business.

Notes


[1] Alawiye-Adams, A.A. and Afolabi, B. (2013). Nigeria Deposit Money Banks’ Credit Administration and the Incidence of Bad Loans: An Empirical Investigation. SSRN (September 23, 2013).

[2] Fagbure, Aderinsola (Aug. 1, 2017). Banks, Loans, and Bad Debts. ThisDay News Paper.

[3] Nwankwo, G.O. (1991). Bank Management: Principles and Practice. Lagos, Malthouse Press Limited.

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