What AreThese Simple Tools and Their Practical Application?
There are a lot of managerial tools, but below are some of the most commonly used ratios that help managers provide the basis for their decisions. They come in different forms like theories or concepts, models, or simple ratios. Managers will only have to be critical in applying them.
Liquidity ratios provide information about a firm's ability to meet its short-term financial obligations. This tool is used by companies that are concerned with their ability to have available funding for the present operations. Businesses like trading and construction companies are the most common types of organizations that find these ratios practical. Trading companies, for example, need to have available funds all the time to meet their daily operational needs.
The most popular under this type is the current asset ratio. Let us take a look at the equation: Current asset/current liabilities: If the company has $300,000 current assets and $150,000 current liabilities, the ratio will be 2:1; for every $1 of current liabilities (trade payables, loan payables, and other short-term liabilities), the company has $2 current assets (cash, accounts receivables, marketable securities, inventories and prepayments) to pay it off.
But being liquid is not enough. Liquidity must be measured in terms of the industry trend: When we say industry trend, what are the rates of other businesses of the same category? If the company's rate is below the trend, it is not performing well; and if the rate is too high, it means that a lot of cash is not used to generate revenues. In the example above, if the industry trend is 1.50:1, the company is performing well compared to the industry.
Asset Turnover Ratios show how efficiently a firm utilizes its assets like buildings constructed for rent, receivables, and inventory. These ratios are called efficiency ratios or asset management ratios. The formula for this ratio is revenue/total assets. If the company has $100,000 and its total assets are $10,000,000, the asset turnover ratio is .01 which means for every $100 asset, the company is only earning one cent. By using this ratio, management will know that investment in assets is not quite good so it has to find ways to utilize assets in order for these to earn revenues.
Financial Leverage Ratios provide indication if the firm can survive a long-term solvency. One example is the debt equity ratio. The formula for this ratio is total debts/total equity and it is ideally 1:1, meaning assets are provided equally by outsiders and inside parties. If the ratio grows higher, there is a fear of insolvency, because what If the company cannot pay its obligations? If the ratio is going down, it becomes an advantage because the company can survive by its own resources.
Profitability Ratios offer several measurements of the firm's success in generating profits. These are the easiest ratios to compute. For the gross margin ratio and net profit ratio, divide the gross margin or net income by the net sales. So if the gross margin is $20,000, net income is $10,000 and the net sales is $100,000, then the gross margin ratio is $20,000/$100,000 or 20%, and the net income ratio is $10,000/$100,000 or 10%.