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  • Danang Firdaus & M. Dimas Novindra

Financial Ratios: A Window into the Financial Performance of a Healthy Company


Cover for an article titled "Financial Ratios: A Window into the Financial Performance of a Healthy Company" by MIB

This article discusses the importance of financial ratios in assessing a company's financial health. These ratios provide insights into various aspects such as a company's ability to pay bills (liquidity), generate profits (profitability), and meet long-term obligations (solvency).


Investors and analysts use these ratios to understand a company's financial position and make informed investment decisions. By analyzing financial ratios, stakeholders can assess a company's ability to meet its financial obligations on time, generate sustainable profits, and maintain financial stability.


Definition and Benefits of Financial Ratios


Financial ratios are a valuable analysis tool in the business world. The definition of financial ratios is a method used to evaluate a company's performance for a specific period. Conducting financial ratio analysis should ideally be done regularly over time, with benefits such as:

  • Understanding the effectiveness of operational management of the company, including budget utilization and required costs.

  • Utilizing financial ratios to assess the optimization of assets used for various activities.

  • Providing information to the company about whether its finances are healthy or in a less favorable condition.

  • Measuring the ability of a business to generate increasing profits, thereby gauging its progress from one period to another.


To calculate financial ratios, companies need to prepare accurate data from financial statements. It is also advisable to prepare financial statements from previous periods for comparison to put more significance into the company's financial ratio reports. Here are the types of financial ratios used to assess the financial performance of a company:

  • Liquidity Ratios: Liquidity ratios are used to measure the company's ability to pay off its short-term debts when they come due.

  • Solvency Ratios: Solvency ratios are used to measure the effectiveness of the company in managing its assets and wealth.

  • Profitability Ratios: Profitability ratios are used to assess the company's ability to generate profits.

  • Activity Ratios: Activity ratios are used to assess the level of effectiveness in using the company's assets.


By using financial ratio analysis, companies can understand their financial performance and take necessary steps to reduce financial risks and improve financial performance.


Liquidity Ratios


The liquidity ratio provides a window into the financial performance of a healthy company. The health of a company can be observed from its ability to meet its short-term obligations, which can be seen from its liquidity ratios. A company with high and stable liquidity ratios can be considered financially healthy because it can meet its short-term obligations and is not likely to experience a shortage of funds.


  • Current Ratio

Formula Current Ratio=Current Asset/Current Liability



This ratio is a comparison between current liabilities and current assets of the company. It shows the company's ability to meet its short-term obligations within a period of 1 year.


  • Quick Ratio

Formula Quick Ratio=Current Asset-Inventory/Current Liability



This ratio is a comparison between current liabilities and current assets, excluding inventory. It indicates the company's ability to meet its short-term obligations within a period of 1 year by disregarding inventory that can be easily liquidated.


  • Cash Ratio

Formula Cash Ratio=Cash + Cash Equivalent/Current Liability



This ratio is a comparison between cash and the company's current liabilities. It indicates the company's ability to settle its short-term obligations with the company's cash reserves.


Interpretation and analysis of liquidity ratios:

  • A company with a liquidity ratio above 1.0 is generally considered healthy. This indicates that the company has current assets larger than its current liabilities, meaning that the company is capable of easily meeting its short-term obligations. 

  • Conversely, a ratio below 1.0 indicates that current assets are insufficient to cover current liabilities. This signifies low liquidity and potential difficulty in meeting obligations.


Solvency Ratio


The solvency ratio is a type of financial ratio used to assess a company's ability to pay its debts. A company with a good solvency ratio can be seen as a company with the ability to consistently pay its debts and thus can be considered financially healthy.


  • Debt-to-Equity Ratio

Formula D/E=Total Debt/Total Equity



This ratio is a comparison between the total debt and equity of the company. The lower the debt-to-equity ratio, the better the company's solvency, as it indicates that the company relies less on debt. The maximum value for the Debt-to-Equity (D/E) ratio is 2.0.


  • Debt-to-Asset Ratio:

Formula D/A=Total Debt/Total Asset



This ratio is a comparison between total debts and total assets of the company. The higher the debt-to-asset ratio, the greater the solvency risk, as this means the company has a high debt obligation. If the ratio value is more than 1.0, it means the company is struggling to pay its debts.


  • Debt-to-Capital Ratio:

Formula D/C=Total Debt/Total Debt + Total Equity



This ratio is an indicator used to measure the capital structure and financial health of a company. Simply put, the debt-to-capital ratio indicates the proportion of debt that a company has compared to all the capital used to finance its operations.


Activity Ratio


The activity ratio is a type of financial ratio used to assess a company's ability to manage its assets efficiently. A company with good activity ratios can be seen as one that efficiently manages its assets and thus can be considered financially healthy. Activity ratios are divided into several types, which includes:


  • Total Asset Turnover Ratio

Formula TATO=Net Sales/Average Total Asset



This ratio is a comparison between net sales and average total assets. It reflects asset activity and the company's ability to generate sales. This ratio indicates the effectiveness of the company in utilizing all its assets to generate sales, where a high ratio suggests that the company is efficient in utilizing its assets. However, it should be noted that industries with intensive capital (such as manufacturing) generally have lower TATO compared to service-based industries because intensive industries have more assets compared to service-based industries.


  • Inventory Turnover Ratio (ITO)

Formula ITO=Cost of Good Sold (COGS)/Average Inventory



This ratio indicates how many times a company's inventory turns over in one year. A high ratio suggests that the company is efficient in managing its inventory. Compared to industries with low inventory turnover (such as heavy equipment manufacturing), industries with high inventory turnover (such as supermarkets) generally have higher Inventory Turnover Ratios (ITO).


  • Receivables Turnover Ratio (RTO)

Formula RTO=Net Credit Sales/Average Accounts Receivable



This ratio is a comparison between total accounts receivable at the end of a period and total sales. It indicates how many times a company's accounts receivable are collected within one year. A high ratio suggests that the company is efficient in collecting its receivables. Industries with primarily cash sales generally have higher Receivables Turnover Ratios (RTO) compared to industries with high credit sales.


  • Fixed Asset Turnover Ratio (FATO)

Formula FATO=Net Sales/Average Fix Asset



This ratio is a comparison between total sales and total fixed assets. It shows how much sales a company can generate for every dollar of fixed assets it owns. A high ratio indicates that the company is efficient in utilizing its fixed assets. Industries with intensive capital (such as manufacturing) generally have lower Fixed Asset Turnover Ratios (FATO) compared to service-based industries.


  • For illustration:

Ratio/Industry

Manufacture

Retail

Service

TATO

1.0 - 2.0

4.0 - 6.0

5.0 - 10.0

ITO

4.0 - 6.0

6.0 - 12.0

N/A

RTO

6.0 - 10.0

10.0 - 20.0

10.0 - 20.0

FATO

1.0 - 2.0

2.0 - 4.0

4.0 - 8.0

It is important to benchmark against similar companies within the same industry to obtain a more accurate picture of good activity ratios for the company. Additionally, companies should also pay attention to industry trends and economic conditions.


Profitability Ratio


The profitability ratio is one of the essential aspects of the financial analysis of a company. A company with high profitability ratios indicates efficiency and the company's ability to generate profits, which is an indicator of the company's financial health.


  • Net Profit Margin

Formula NPM=Net Profit/Revenue



This ratio measures the company's net profit as a percentage of total revenue. The higher the net profit margin, the more efficient the company is in generating net profit from sales.


  • Gross Profit Margin

Formula GPM=Revenue-Cost/Revenue



This ratio measures the percentage of gross profit against the revenue generated. The larger the gross profit margin, the better the operational activities of the business.


  • Return on Equity (ROE)

Formula ROE=Net Income/Shareholder's Equity



This ratio measures the return on equity (ROE), indicating the level of return on investment for shareholders. The higher the ROE, the better the company's performance in generating profit for shareholders from the equity they own.


  • Return on Assets (ROA)

Formula ROA= Net Income/Total Asset



This ratio measures the company's ability to generate profit from its assets. The higher the Return on Assets (ROA), the better the company's performance in generating profit from its assets.


  • Return on Investment (ROI)

Formula ROI=Net Income/Cost of Investment



This ratio measures the level of return on investment for shareholders or company owners. The higher the Return on Investment (ROI), the better the company's performance in generating profit from the investments made.


  • Operating Profit Margin

Formula OPM=EBIT/Revenue



This ratio measures the percentage of the company's operating profit from total revenue. The higher the operating profit margin, the more efficient the company is in generating operating profit from sales.


Interpretation and analysis of profitability ratios:

  • In general, high profitability ratios indicate good company performance. However, the optimal value of profitability ratios varies across industries and depends on various factors such as company strategy, cost structure, economic conditions, and risk levels.

  • Analysis of profitability ratios should be done comprehensively by considering a variety of factors, not only by focusing on one ratio. Comparison with industry norms and historical trends of the company is also necessary to obtain a thorough picture of company performance.


Conclusion


Analyzing financial ratios is a method of evaluating a company's performance by comparing various financial data. Financial ratios are crucial in investment decision-making and credit assessment processes because they provide insights into a company's performance, capabilities, efficiency, and financial health. Financial ratios facilitate decision-making by offering an overview of a company's ability to generate profits, manage assets, and meet obligations. However, financial ratio analysis has limitations as it does not consider external conditions such as the market, prices, or economic conditions. Obtaining an all-inclusive understanding of a company’s performance can be done with the additional help of qualitative analysis, which involves gathering information about the company, market conditions, and economic conditions, as well as evaluating strategies, management, and company performance.


It is important to conduct financial ratio analysis holistically to avoid bias. For example, although manufacturing company PT XYZ has a high net profit margin ratio of 20%, indicating good profitability, its debt-to-equity ratio of 2.3 suggests that the company has a significant debt burden. The combination of these two ratios indicates that the company has high exposure to financial risk because its profits can be significantly affected by debt interest expenses. Therefore, evaluating financial ratios can offer support in assessing company performance, making investment and credit decisions, and supporting business management. However, financial ratio analysis should be done carefully and in conjunction with qualitative analysis to provide a more comprehensive and accurate understanding of the performance of a company.


 

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