Which Financial Ratios are Used to Assess the Viability of A Business?
May 31, 2021
Proposals for financial assistance are presented to the lenders in a document. They analyze the same to determine the viability of the project. Investors are attracted to your proposal when there is a potential for a good return. On being satisfied, they become competitively inclined to lend.
These lenders perform a TEV study to assess the viability of a proposal based on some benchmark financial ratios. Let us understand these ratios and their importance.
Financial ratios refer to the numerical values in the financial statement to conclude detailed information about the business. A TEV study is undertaken and qualitative analysis of the balance sheet, income statement, cash flow, etc., is done to analyze the financial indicators. All financial aspects, such as profitability, growth, return rate, liquidity, etc. are evaluated through this method.
This exercise aids in:
- Evaluating the performance of an organization- The difference in the numerical values over a period of time is analyzed through these ratios. Any unusual difference in the values helps to eliminate the risk of increasing the debt to asset ratio.
- Comparison of the company performance- These financial ratios are also utilized to compare a company's performance with the others. It helps to identify if the company is performing at par with the industry standards.
Types of Financial Ratios
These are in many forms and are used to find out the feasibility of a proposal using the TEV Study. Some are mentioned as follows:
- Liquidity Ratios- Liquidity ratios are an important class of financial metrics used to determine a debtor's ability to pay off current debt obligations without raising external capital. Liquidity ratios measure a company's ability to pay debt obligations and its margin of safety through the calculation of metrics including the current ratio, quick ratio, and operating cash flow ratio. With liquidity ratios, current liabilities are most often analyzed in relation to liquid assets to evaluate the ability to cover short-term debts and obligations in case of an emergency.
- Efficiency Ratio: Efficiency ratios, also known as activity ratios, are used by analysts to measure the performance of a company's short-term or current performance. An efficiency ratio measures a company's ability to use its assets to generate income. For example, an efficiency ratio often looks at various aspects of the company, such as the time it takes to collect cash from customers or the amount of time it takes to convert inventory to cash. This makes efficiency ratios important because an improvement in the efficiency ratios usually translates to improved profitability.
These ratios can be compared with peers in the same industry and can identify businesses that are better managed relative to the others. Some common efficiency ratios are accounts receivable turnover, fixed asset turnover, sales to inventory, sales to net working capital, accounts payable to sales, and stock turnover ratio.
- Market Prospect ratios- are used to compare publicly traded companies' stock prices with other financial measures like earnings and dividend rates. In other words, market prospect ratios show investors what they should expect to receive from their investment. This is used by investors to predict how much profit they can generate through certain investments. Their revenue can be in the form of a higher stock value or future earnings. Some of these market ratios include price to earnings ratio, dividend payout yield, earning per share, etc.
- Solvency Ratios- A solvency ratio is a key metric used to measure an enterprise's ability to meet its long-term debt obligations and is used often by prospective business lenders. A solvency ratio indicates whether a company's cash flow is sufficient to meet its long-term liabilities and thus is a measure of its financial health.
- Profitability Ratio: is used to evaluate the company's ability to generate income as compared to its expenses and other cost associated with the generation of income during a particular period. This ratio represents the final result of the company. A higher profitability ratio as compared to previous years shows that a business is doing well. Besides, one can also compare the profitability ratio of a company by comparing its competitor in the market.
- Wrap Up: Financial ratios provide a clear picture of the overall functioning of your business. It helps banks and financial institutions to make decisions about funding your business proposals.
Assessing the financial ratios through a TEV Study would also keep you updated with the functioning of your business. It is prudent to consult an expert when it comes to getting your business proposal assessed.