Last Updated 10 May 2020

# Utility of the Financial Ratios

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“Financial ratios can be used to analyze trends and to compare the firm's financials to those of other firms. In some cases, ratio analysis can predict future bankruptcy. ” (NetMBA) 4. 1 Liquidity Ratios: The liquidity ratios provide the information and analysis about the capabilities of the firm to meet its short term financial obligations. These ratios clearly guide the lenders who want to advance monies to the companies on a short term basis.

‘Current Ratio’ or ‘Working Capital Ratio’ and the ‘Quick Ratio’ are the two important liquidity ratios that are being looked in to for assessing the financial ability of the company. Basically these ratios compare the current assets position of the companies with the current liabilities and enable the determination of the liquidity of the company. ‘Cash Ratio’ is another form of ratio that compares the liabilities with only the cash or cash equivalent assets of the company. 4. 2 Asset Turnover Ratios:

These are the ratios “which use turnover measures to show how efficient a company is in its operations and use of assets” (Financial Pipeline) ‘Receivables Turnover’ ‘Average Collection Period’ ‘Inventory Turnover’ are some of the important turnover ratios that indicate how efficiently the firm has utilized its assets over the analysis period. These ratios are related to sales and cost of goods sold. The turnover ratios are calculated and measured over a period of 3 to 5 years and they help an in-depth analysis in the areas of operational results of the firm. 4. 3 Financial Leverage Ratios:

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The financial solvency of the firm over a long period of time is brought out by the financial leverage ratios. While the liquidity ratios measure the short term financial stability of the firm the leverage ratios exhibit how well the company has used the long term funds. ‘Debt Ratio’ ‘Debt – to – Equity Ratio’ ‘Interest Coverage’ are the important ratios that are included in this head. 4. 4 Profitability Ratios: “These ratios are used not only to evaluate the financial viability of any business, but are essential in comparing the business to others in the industry.

One can also look for trends in the company by comparing the ratios over a certain number of years. ” (BDC) ‘Net Profit Margin’ ‘Operating Profit Margin’ Return on Equity’ are some of the important ratios under this category. These ratios are based on the gross and net income of the company and the sales and the cost of sales. 4. 5 Dividend Policy Ratios: The most important financial ratios from the point of view of the investors and the stakeholders are the dividend policy ratios.

‘Dividend yield’ ‘Payout Ratio’ ‘Earnings per Share’ are the most commonly used ratios about the dividend payment of a firm. These ratios are calculated on the basis of the dividend payments and the market price of the shares. 5. 0 Conclusion: Since the financial ratios measure and reveal the performance of the company in the following areas which cover the whole spectrum of the financial strength of the firm it can be said that financial ratios are effective means of examining the performance of a business.

? Short term liquidity position of the company ? Operational efficiency of the company ? Long term solvency of the firm ? Profitability of the firm and ? Dividend policies which affect the interests of the stakeholders and investors Moreover the calculation and interpretation of these ratios are simple and thus it can be concluded that the “Financial ratios provide a quick and relatively simple means of examining the financial performance of a business” 6. 0 Case Study – Imperial Tobacco

As a case study the paper analyses the financial performance of Imperial Tobacco Plc one of FTSE 100 companies based on the published financial statements of the company for the year ended 30th September 2006, the latest available results. 6. 1 Imperial Tobacco – a Brief Background: Imperial Tobacco is the world’s fourth largest international tobacco company which manufactures markets and sells a comprehensive range of cigarettes, tobaccos, rolling papers and tubes. Imperial tobacco products are available in over 130 countries worldwide.

The company has 21 cigarette factories, 8 other tobacco product factories and 3 papers and tube factories. Imperial Tobacco have transformed the Group into a multi-national tobacco business and they are now well-placed to capitalise on this strengthened international position and derive full value from our acquisitions. Imperial Tobacco has shown year on year growth for the last six years and they continue to see real growth potential in a number of selected markets including Central and Eastern Europe, the Middle East, Africa and Asia.

In the six years since Imperial Tobacco became an independent company and their listing on the London Stock exchange, operating profit has grown over 110 per cent from ? 373 million to ? 789 million. (Source www. imperial-tobacco. com) 6. 2 Financial Ratios: The key financial ratios and an analysis of the ratios are as follows: A. Liquidity Ratios: The important liquidity ratios are discussed as under: 1. Current Ratio: The current ratio of the company stands at 0. 72 for the year 2006. However for the year 2005 the ratio was 0.

86 implying that the liquidity of the company for the year has come down. This ratio implies that the company does not have good short term liquidity. Normally a current ratio of 1. 33 is considered to be a sound current ratio indicating the ability of the company to meet its short term liabilities. The lower current ratio implies that the company’s current liabilities are getting due within a short term and the company has to make arrangements for meeting these liabilities as it doesn’t have the liquid sources to meet the liabilities.

2. Quick Ratio: The quick ratio takes into account the receivables and other current assets in the calculation of the liquidity ratio. In the case of the financial performance as depicted by the balance sheet of the company the quick ratio is 0. 457. (For 2005: 0. 520) Although there are no comparable standards for this ratio, the ratio for the company seems to be at a low level signifying that the company’s liquidity in terms of realizable assets other than inventory is poor and has deteriorated from the last year. 3. Cash Ratio:

This liquidity ratio compares the current assets in the form of cash and cash equivalents against the current liabilities. In this case the cash and cash equivalent assets of the company would be able to meet 0. 101 times (2005: 0. 119) of the current liabilities only which again is a poor state of affair. B. Asset Turnover Ratios The Asset turnover ratios indicate how efficiently the company has used its assets over the past period. Normally the turnover ratios can be calculated on the basis of the credit sales alone. However the ratios calculated over the total sales also indicate the efficiency of the firm.

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