In recent decades, creditors and investors are increasingly relying on financial ratios released by firms to analyze fundamental information about the organizations’ financial position, performance and health (Malikova & Brabec, 2012). This paper evaluates four financial ratios, namely asset turnover ratio, debt ratio, return on capital employed and acid test ratio, not only to identify what these ratios say about a firm but also to understand what they mean to lenders and investors.
One of the most used financial ratios is the asset turnover ratio, which “examines how effectively the assets of the company are being used to generate sales revenues” (Malikova & Brabec, 2012 p. 152). In this light, this financial ratio carries critical information about how senior management is using the firm’s total assets to generate the needed sales and sustain competitive advantage. According to Alireza et al (2012), a higher asset turnover ratio is important for potential investors as it demonstrates a firm’s capacity to use the available assets more productively so as to achieve competitiveness and higher performance due to the increase in sales revenues. Within the banking domain, a firm with a high asset turnover will definitely receive positive credit rating due to its capacity to repay the credit.
The second ratio is the debt ratio, which “represents the first and the broadest test of indebtedness of the company so that it expresses the relation between the total debt, both current and long-term, and total equity and liabilities of the company” (Malikova & Brabec, 2012 p. 152). As such, it can be argued that this ratio is able to relay information about the indebtedness of an enterprise in relation to its total equity. Individuals wishing to invest in a firm must understand this ratio if they want to know whether a company has the capacity to attract both short-term and long-term lenders, and hence remain competitive in the market (Zager et al., 2012). Equally, companies that are able to maintain a low debt ratio by minimizing the level of liabilities often succeed in attracting creditors (banks) and minimizing the potential risks for the owners of the firms (Dennis, 2006).
The third ratio is the return on capital employed, which basically “expresses the relationship between the profit generated from operating activities and the capital invested into the company” (Malikova & Brabec, 2012 p. 151). This ratio is important not only because it represents a fundamental measure of business performance of the firm, but also because it ensures superior comparability among several companies since the outcomes are not influenced by the capital structure of the firm as well as by taxation in various countries if both interest and taxes from the profit figure are eliminated when computing the ratio (Bull, 2005). When making investment or lending decisions, banks and investors should aim to comprehensively understand this ratio as it impacts directly on their decisions based on the fact that firms with a lower return on capital employed ratio may not be in a position to make good profits to investors, or to repay credit provided by banks due to their poor performance.
Lastly, it is important to assess the acid test ratio, which “is derived from a current ratio and represents a stricter view on a company’s liquidity because current assets that cannot be converted into cash quickly as for example inventories or doubtful debts are not contained in this ratio” (Malikova & Brabec, 2012, p. 152). Consequently, this ratio is important to a firm as it indicates the capacity to turn current assets into cash, hence the ability of the business enterprise to meet its current obligations with available assets that can easily be converted into cash (Dennis, 2006). A higher acid test ratio is good for investors as well as potential lenders as it demonstrates the capacity of the firm to repay its immediate commitments, hence avoiding such issues as bankruptcy and poor credit rating (Zager et al., 2012).
References
Alireza, F., Parvis, M., & Mina, S. (2012). Evaluation of the financial ratio capability to predict the financial crisis of companies. IUP Journal of Behavioral Finance, 18(2), 57-69.
Bull, R. (2005). Financial ratios. Financial Management, 8(2), 34-35.
Dennis, M. (2006). Key financial ratios for the credit department. Business Credit, 108(10), 62-62.
Malikova, O., & Brabec, Z. (2012). The influence of a different accounting system on informative value of selected financial ratios. Technological & Economic Development of Economy, 18(1), 149-163.
Zager, K., Sacer, I.M., & Decman, N. (2012). Financial ratios as an evaluation instrument of business quality in small and medium-sized enterprises. International Journal of Management Cases, 14(4), 373-385.