For ratios to be useful, they must comprise reliable and accurate financial information. When performing a financial ratio analysis, generally the numbers from classified financial statements are used, such as the amounts on the balance sheet and the income statement. Financial ratio analysis can be used either internally or externally, most of which is intended for a comparison of financial information from period to period. Perhaps a company’s management wants to determine any trends or issues that may have developed over time, or if certain creditors or lenders require the use of financial ratios to make an informed business decision regarding an investment. Financial ratio analysis is also meaningful when used to make impartial comparisons across other companies within the same industry. Although, despite any successful findings from a financial ratio analysis, these ratios should also be carefully interpreted in the appropriate context with an understanding that additional factors and metrics may be needed when assessing the performance of a company.
The concept of a performance ratio is to evaluate the functionality of a business’s core operations while determining how well resources are used to generate sales/cash. Management can apply different performance ratios to see which of their goals are being met and what areas of the business operations might need improvement. Some of the standard performance ratios a company may use include: Days Sales Outstanding, Days Inventory Outstanding, Days Payable Outstanding, and the Cash Conversion Cycle. Most of these ratios should be used internally before comparing them to other companies in the same industry. Additionally, if one of the company’s performance ratios is deemed “poor”, then most likely, other performance ratios will also reveal an ineffectiveness to generate significant cash inflows.
Efficiency ratios are used as a measurement of how effectively a business manages its resources to generate a profit. If a company wishes to determine how well it uses its assets and liabilities, then the application of efficiency ratios will show the company’s current performance while also evaluating the operations of the business. Efficiency ratios should most likely be used internally and not cross-analyzed with other industries since most industries have different ratio quantifications. Accounts Receivable Turnover, Asset Turnover, Inventory Turnover, and Inventory to Sales are some examples of efficiency ratios.
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