Must know for HR..Basic understanding of Business Finance - Part 7

In continuation of my previous post where we deliberated on Liquidity ratio, in this post, let us understand other 2 ratios i.e. Profitability and Efficiency. 

2. Profitability Ratio: They are used to assess business's ability to generate earnings as compared to its expenses and other relevant costs incurred during a specific period of time.These ratios measure and help control income. 

The net profit ratio measures the effectiveness of management. This is a valid comparison between firms in the same industry. This ratio filters any distortions that may occur because of high debts or other factors that may affect the tax payments or lack of tax payments. Filtering out the effects of debts and taxes is useful for 2 reasons :1st Taxes may be high or lower because of events other than the operations of the business. 2nd High debt payments such as those found in new start business could distort earnings so that the comparison to other companies is skewed. Net profit ratio = earnings before interest and taxes (EBIT)/Net sales. A low net profit is not good, it could indicate that the expenses are too much for the sales volume. On the other hand high ratio indicates either that expenses are being held down or that the company may be getting more out of its assets and debts.

Rate of return on sales ratio measures how much net profit was derived from each sales rupee. It indicates how well you have managed your operating expenses. It may also indicate that whether the business is generating enough sales to cover the fixed costs and still leave an acceptable profit. Rate of return on sales = Net profit/Net sales. A low rate of return on sales is not necessarily bad if your industry operates on low margins and high volume. A high rate is usually good if other things are in line, if payments are being kept up, assets replaced, and other expenses are not deferred. Usually the higher ratios are better however, if you are beating last year’s figures and show steady increase, you are on the right track.

Rate of return on investment measures how much net profit was derived from the shareholder’s investment in the company. Rate of return on investment = Net profit/Net worth which is equal to share holders equity. A low ROI means that other investment may be better, it could mean that management is inefficient or that the company is too conservative and not earning up to its potential. On the other hand a high rate indicates that borrowing may be the source of much of the capitalization or that management is extremely efficient or that the firm is under capitalized.

Rate of return on assets measures the profit that is generated by the assets of the business. Rate of return of assets = Net Profit/Total Assets. A low rate of return on assets indicates poor performance or poor use assets by management. On the other hand a high rate indicates good performance and good use of assets. It is important to watch out if the fixed assets of the business are heavily depreciated or there are large amounts of unusual expenses or income.

3. Efficiency Ratio: - These ratios measure and help control the operations of the business. They help in increasing income by assessing such important transactions such as use of credit, control of inventory and management of assets.They provide quick indications of how well your credit policy is working and your inventory is moving.They help keep the business in balance. 

Following are the Efficiency Ratios :

Time it takes to collect outstanding receivables = Accounts receivable x 365 days per year/Net sales

Inventory Turnover ratio which measures how fast goods are moving

Investment Turnover ratio measures the amount of sales generated by assets forms part of efficiency ratio.

Ratio of fixed assets to Net Worth measures the portion of Net Worth that is made up of fixed assets

Another important measure that is employed is Debt-to-Equity Ratio : A measure of a company's financial leverage. Debt/equity ratio is equal to long-term debt divided by common shareholders' equity. Investing in a company with a higher debt/equity ratio may be riskier, especially in times of rising interest rates, due to the additional interest that has to be paid out for the debt.

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