FINANCE Essay Example
Financial ratios break down raw financial information into a form that is easy to understand. Managers can then use ratios to identify trends related to profitability, liquidity, solvency, and turnover and make appropriate strategic decisions. For instance, a fall in the quick ratio will indicate a trend where the firm is taking too long to collect receivable or that the firm is over-leveraged. Financial ratios are also important as they allow firms to judge their managerial and operational efficiency, strengths, and weaknesses. For example, the return on assets ratio determines whether management is effective in utilising assets to generate profit. In summary, financial ratios are important in understanding the health of a firm as they break down data into standard ratios that describe profitability, liquidity, efficiency, and solvency that facilitate strategic decision making.
Financial ratios facilitate comparison of financial performance across an industry because of standardisation. This means that the ratios provide an accurate representation of profitability, efficiency, solvency, and liquidity regardless of the size, market share, or sales volume of a company. Therefore, a small retail firm can compare its effectiveness in utilising assets to generating profit with a large retail store using the returns on assets ratio. Financial ratios are also important in comparing firms since historical data can be used to create performance benchmarks. For example, the airline industry can have a benchmark net profit margin of 5%. This allows investors, creditors, security analysts, and other industry observers to compare the performance of individual carriers in the industry and make informed decisions.
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