Financial ratios and their implications along with their usage Literature review

Financial ratios and their implications along with their usage - Literature review Example This essay discusses that financial ratios have been used by firms around the world to analyse how one firm performs in comparison to the other firm as well as to analyse the performance of the firm over the period of years. Therefore management calculates and uses financial ratios to identify the performance gap of the firm against its own past performances as well as against the performance of competing firms in the industry. In addition to this, management uses to analyse the financial performance of the firm against the average financial ratios of the firms operating in the industry as well and then identify areas where the firm has not been performing up to the mark. Some organisations use the financial ratios for the purpose of benchmarking as well and they tend to set different targets for different kinds of financial ratios and then make efforts to achieve these financial ratios. For instance, a firm would like to achieve a profit margin of 20% and therefore in order to achie ve this profit margin, the company would be making efforts to reduce the cost of the company or generate more sales so that costs is allocated to more sold units and targeted profit margin is achieved. Financial ratios are an important indicator about the performance of the firm and therefore it has been used not only by the management of the organisation but these financial ratios have also been used by investors, shareholders, suppliers, distributors and other stakeholders to analyse the financial performance of the company. ... Financial ratios can be subdivided into five major types of financial ratios on the basis of what these ratios reflect: 1. Profitability Ratios 2. Liquidity Ratios 3. Activity Ratios or Efficiency Ratios 4. Leverage Ratios 5. Market Ratios There are different financial ratios included in each of the five categories discussed above and each type or of ratios have their own importance and implications. TYPES OF FINANCIAL ratios Profitability Ratios Profitability ratios reflect how the firm is making profits using the assets or resources it has (Kaplan, and Atkinson, 1998). There are different types of profitability ratios and some of the most important profitability ratios have been discussed below: Profit Margin Profit margin of the firm is calculated using two variables; net profit of the company and the net revenue or net sales. Profit margin reflects the percentage of profits the firm earns out of the total revenue it generates. Formula for calculating profit margin is as follows: Higher profit margin of the firm shows that the cost of making profits is low and lower profit margin indicates that the cost of the company is high. Negative value of profit margin indicates a loss. Gross Profit Margin Gross margin of the firm reflects the profits generated by the company after deducting the production cost (Khan, 1993,). Higher gross profit margin reflects that the cost of production of the firm is low and vice versa. The formula for calculating gross margin is as follows: Operating Margin or Operating Profit Margin Operating profit margin of the firm reflects the ratio of operating profits of the firm against the net sales (Atkinson, Kaplan, Matsumura, & Young, 2007). Operating profit margin can be calculated using the following ratio: Operating