Financial and Managerial Accounting

Introduction

Financial ratios are tools of quantitative analysis that allow business owners and planners to determine the financial standing or financial credibility of the business entity during performance management (Bragg, 2012). Financial ratios apply statistical and mathematical calculations to the financial information of a business entity and provide a comprehensive and precise snapshot of its financial performance. The function of financial ratios is to provide managers with a performance benchmark so that they have sufficient financial data to conduct a comparative analysis.

This comparative analysis allows them to assess the company's leading financial ratio indicators and compare them with a direct competitor or the existing industry standard. If the financial indicators of a small business fall below industry standards, it clearly indicates that the business is not operating with optimum efficiency. Conversely, if the financial indicators of a business are higher than the existing standard in that specific industry, it is an indication that the company is functioning more efficiently than other rivals under existing market conditions (Bragg, 2012).

Discussion

The most commonly used financial ratios include profitability, liquidity, financial leverage and asset turnover calculations. Profitability ratios determine the individual level of profitability achieved by different categories of goods or services while liquidity ratios aid managers in assessing the business' capacity to successfully address short-term financial obligations. Financial leverage calculates the long-term solvency of the small business and asset turnover ratios provide managers with critical indicators that educate them on the efficiency of the business in converting business assets into sales revenue. The following is a list of financial ratios that are commonly used by businesses:

Profitability Ratios

Profitability ratios assist the users of a business' financial statements in determining management efficiency in terms of returns recorded through the sales and investment activities (Tamari, 1978). Profitability ratios generally include calculation of gross profit margin, net profit margin and operating profit margin. Gross profit margin gauges the profitability of a business entity by taken into consideration the cost of goods sold while operating profit margin determines the same by reviewing its earnings before the payment of interest and tax. The net profit margin is the most comprehensive of all margins and is more commonly referred to as the “bottom line” as it assesses the profitability of a business entity by taking into account all the expenses.

Efficiency Ratios

This ratio assesses the effectiveness of decisions made by the management. It assesses various aspects of the business such ...