A class of financial metrics that are used to assess a business’s ability to generate earnings as compared to its expenses and other relevant costs incurred during a specific period of time. For most of these ratios, having a higher value relative to a competitor’s ratio or the same ratio from a previous period is indicative that the company is doing well. These ratios can indicate a company’s productivity of capital used, productivity of total asset used, and effectiveness of pricing policy.
Next, these ratios provides a greater insight of the financial performance in a company, in other words, it determines if the company is making a good profit and return on its asset and investment. These ratios can also tell us how well the company is managed compared to the industry average. Under this category we can find four sub-divisions:Return on capital employed: it is the percentage obtained from the net profit before interest and taxation divided by the capital employed which reveals the business performance, taking into account the long-term capital invest and the profit generated by it.
Furthermore, it also indicates that the efficiency and profitability of a company’s capital investment. In other words, it is an indicator of how well a company is utilizing capital to generate revenues. It should be normally higher than the rate company borrows at, otherwise any increase in borrowings will reduce shareholders’ earnings. Return on equity or return on ordinary shareholder’s funds: it express on percentage the profits for the shareholders according to their stake in business.
A ratio that measures a company’s earnings before interest and taxes (EBIT) against its total assets. The ratio is considered an indicator of how effectively a company is using its assets to generate earnings before contractual obligations must be paid. The greater a company’s earnings in proportion to its assets, the more effectively that company is said to be using its assets.
Gross profit margin: percentage obtained from the division of the gross profit (difference between sales and the cost of sales) of a company and the sales which gives us the profitability before other expenses are taken into account. However, if the company has low gross profit margins may be it due to insufficient sales volume or higher costs of goods sold. Costs of goods sold may be higher due to expensive sources of goods. It could also be due to higher labour costs, high production wastage and lower selling price.
Net profit margin: it is the result of the net profit before interest and taxation which represents the profit before any expenses of servicing long-term finance are subtracted divided by sales and then multiplied by 100 to get the percentage. Hence, It measures how much out of every dollar of sales a company actually keeps in earnings. Profit margin is very useful when comparing companies in similar industries. A higher profit margin indicates a more profitable company that has better control over its costs compared to its competitors.
These ratios can measure a company’s ability to convert different accounts within their balance sheets into cash or sales. Companies will typically try to turn their production into cash or sales as fast as possible because this will generally lead to higher revenues. Hence, these ratios will indicate whether the assets are too high, too low or reasonable for the firm’s current and projected operating levels. They show the amount of sales generated for every dollar of asset investment. These ratios are meaningful when compared to peers in the same industry and can identify business that is better managed relative to the others.
Also, efficiency ratios are important because an improvement in the ratios usually translate to improved profitability. Asset turnover: measures a firm’s efficiency at using its assets in generating sales or revenue – the higher the number the better. It also indicates pricing strategy: companies with low profit margins tend to have high asset turnover, while those with high profit margins have low asset turnover. This ratio is more useful for growth companies to check if in fact they are growing revenue in proportion to sales.
Stock turnover: measures how well a company coverts stock into revenues. It is closely similar to asset turnover and is also a measure of efficiency. Stock turnover is more specific than asset turnover. It measures how well the company is making use of the part of its working capital that has been invested in stock. A too high inventory means higher carrying costs and higher risk of stocks becoming obsolete whereas too low inventory may mean the loss of business opportunities. It is very essential to keep sufficient stock in business.