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Financial Ratios - Essay Example

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The financial statement prepared with the help of financial ratios is an aid to find out the efficient operation of the business for the share holders, competitors, and outsiders who are willing to invest in the firm. These ratios play a key role in calculating the dividend to shareholders, interest to debenture holders, as well as the tax payable to government. They also express the risk factor and bankruptcy chances of the firm. Theory of Financial Ratios There have been no convincing theories on financial ratios over the years. Horrigan (1965), writes on how the financial ratios were originated and how the theories were not. He says that a unique outcome of the accounting evolution in the United States was the development of financial ratios which helped in analyzing accounting statements. Such ratios were originally formulated for using as short-term credit analytical devices. The origin of such ratios can be traced out as far back as the late 19th century. A number of various financial ratios were developed by the analysts in the early decades of the century. The next step after the formulation of such ratios was the development of body of empirical generalization about such financial ratios which later turn out to be the hypothesis for drawing out theory of financial ratio analysis. However, the materialization of a system of empirical generalization never happened, much less a theory (Horrigan, 1965). Sources of Information for the Calculation of Financial Ratios There are a number of sources for the collection of the information for financial ratio analysis. The Profit and Loss Account and the Balance Sheet serves as the main source for information. Some of the most commonly used sources for accumulating information for analysis are given below. Trial Balance Trading Account Profit and Loss Account Profit and Loss appropriation Account Income Statement Cash-flow Statement Fund-flow Statement Balance Sheet Bank Statements Categories of Financial Ratios. There are numerous financial ratios used in the financial statements and policies. These ratios are categorized on the basis of information they give. Some of the frequently used ratios are: Profitability ratios, Dividend Policy ratios, Asset turnover ratio, Liquidity ratio and Leverage ratio. Profitability Ratio: - The profitability ratio expresses the success of the firm and the profit margin of the firm. The profitability ratio includes Gross Profit Margin, Return on Asset (ROA), Return on Equity (ROE), etc. The gross profit margin is used to determine the gross profit earned over sales, considering only the cost of goods sold and excluding all other items. Gross Profit Margin = Sales – Cost of goods Sold Sales Dividend Policy Ratios: - The dividends to the share holders are paid out in the most suitable way using the dividend Policy Ratios. The generally used ratios are Dividend Yield Ratio and Payout Ratio. Dividend Yield Ratio = Dividend per Share Share Price Payout Ratio = Dividends per Share Earnings per Share Asset Turnover Ratios: - The efficiency in utilizing the assets of the business is pointed out by the Assets Turnover Ratios. One of the commonly used Asset Turnover ratios is Receivables Turnover ratio indicating the speed of collecting the accounts receivable of the firm. Receivables Turno ...Show more
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Summary

Financial Ratios (College) Financial Ratios Introduction Financial ratios, often called accounting ratios are used in the financial analysis by comparing two financial items extracted from the financial statements. Financial ratio is defined as “The relationship between two accounting figures expressed mathematically”…
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