Importance of Financial Ratios Essay Sample

Importance of Financial Ratios Pages
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The main purpose of this report is to analyse importance of different types of financial performances and to compare financial ratios of Chancellors Hotel and Conference Centre with another business in the same industry and industry averages. It is owned by The University of Manchester and it is located in Fallowfield, Manchester, United Kingdom, which is close both to Manchester City Centre and Manchester Airport. Thus, it is situated conveniently and the prices for accommodation are lower than in the city centre. It is a three star AA rated hotel with excellent transport links to all key Manchester shops and attractions, which offers a lot of facilities such as on-site parking places for customers, 70 en-suite bedrooms, conferences and meeting rooms, first class restaurant, lounge and bar, free wi-fi and internet access. Moreover, the Hotel provides different events, including Garden Parties, Barbecues, Family Celebrations, Corporate Events, Dinner Parties, Sunday lunch, Afternoon Tea, Christmas Parties, Exhibitions and etc. [3] .

Main Body

It is essential to analyse the nature and importance of financial ratios, because financial ratios picturize the strengths and weaknesses of a business. Ratio analysis helps to identify problem areas and opportunities within the business. Financial analysis could help in forecasting and drafting future plans for the company and it allow managers to set particular goals and to readily track progress of those. Financial ratios are significant in a variety of areas, particularly in the hospitality industry. Moreover, ratios help to compare different companies between each other. There are vast amounts of financial ratios available, below are explanations of the most important financial ratios [2]. Profitability ratios

These types of ratios illustrate how well a business is performing. Profitability ratios display a company’s overall productivity and effectiveness. We can divide profitability ratios into three main types: 1. Gross Profit Ratio

2. Net Profit Ratio
3. Return on Capital Employed (ROCE)

Gross profit ratio

Gross profit ratio expresses relationship between gross profit and sales. Usually Gross Profit ratio is expressed as a percentage. Gross Profit Ratio % = (Gross profit/sales)*100

This ratio shows how efficiently a company is using its belongings and production efficiency of the business. The higher the Gross Profit ratio earned the better is for businesses, this means that business retains more money of each pound of sales, which indicates more money is left for other expenses. However the Gross Profit should be satisfactory to recover all current expenses. A low Gross Profit ratio means that company has a poor level of income to pay for expenses. It states that business is unable to control its production costs [10].

Net profit ratio

Net profit ratio indicates the remaining profit after all types of operating expenses have been deducted from sales. This type of ratio shows the overall efficiency of the business. It indicates a company’s net income per pound of sales. Net profit ratio is expressed as a percentage [1]. Net Profit Ratio % = (Net profit/sales)*100

The higher Net Profit ratio, the better is for the business.

Return on Capital Employed

Return on Capital Employed or ROCE is an amount of returns that company expects from its capital. ROCE is calculated as net profit divided by the capital in the end of the year and is expressed as a percentage. In consequence ratio indicates how effectively invested capital is being used to produce profit. Return on Capital Employed (ROCE) % = (Net profit/Capital in the end of year)*100

Liquidity ratios

These types of ratios show a company’s capacity to pay its bills. If Liquidity ratios are higher than 1:1, this means that the company is in good financial situation and less likely to fall into financial hardship. These are most common examples of liquidity ratios: 1. Current Ratio

2. Acid Test Ratio
Current ratio

The Current ratio indicates how many times company can cover its current liabilities. This ratio displays relationship between company’s amounts of assets to its liabilities, which shows its opportunity to pay its debts [9].

Current Ratio = Current Assets / Current Liabilities : 1
Acid Test ratio

The Acid Test ratio displays how well a company can meet its current liabilities. In another words, it is substantial that a company have enough cash to cover all of the short-term expenses. The companies with Acid Test ratio which is greater than 1.0 are less likely to have financial difficulties. If ratio is lower than 1.0 that means that company’s liquid assets could not cover its current liabilities. The higher the ratio, the more secure company is. Low ratio indicates that company pay its bills very quickly or collecting money from debtors too slowly [6]. Acid Test Ratio = (Current Assets – Closing Stock) / Current Liabilities : 1

Working Capital Management Ratios

Managing Working Capital is one of the most essential jobs for managers and accountants in any businesses. There should be perfect balance between current assets and current liabilities to successfully operate and do not have any financial difficulties. Working Capital Management (WCM) is the process of balancing company’s current assets and current liabilities. In other words, WCM is the process of managing daily, weekly and monthly cash flow of a business in such a way that covers all expenses while saving enough capital to continue generating profit [4]. These are most common examples of ratios which show managers the condition of the company’s working capital: 1. Stock Turnover Days

2. Debtor Collection Days
3. Creditor Payment Period

Stock Turnover Days

This ratio shows how often company’s stock is sold and replaced over the period of time. A low ratio implies poor sales or bad stock control. A high ratio implies good sales or ineffective stock control [7].

Stock turnover Days = Average stock/cost of sales * 365
Debtor Collection Days

This ratio indicates on how many days it takes to a company to receive payment from its debtors or to get paid for what company sells. The lower is ratio, the better for business. High ratio indicates dubious sales figures or potential bad debts.

Debtor Collection Days = Debtors/Credit Sales * 365
Creditor Payment Period

This ratio shows how long does it take to a company to pay its debts to its creditors/suppliers. High ratio can cause problems with suppliers and loss of good offers. Low ratio can indicate good financial health or can cause problems with other expenses, so this ratio should be neither high, nor low [8].

Creditor Payment Period = Creditors/Credit Purchases * 365

Comparison of the Financial Ratios

The best way to see how operates business is to explain importance and meaning of the financial ratios and to compare this business with another business from the same industry and with Industry Average ratios. According to analysis of my findings from the attached Excel file, below are shown financial ratios from the final accounts of the Chancellors Hotel and Conference Centre. In addition, I decided to compare financial ratios with similar business’s ratios. I chose Castlefield Hotel Limited, which is situated also in Manchester and is a three star rated hotel as well as Chancellors Hotel. In accordance with online source FAME database, below are shown financial ratios of the Castlefield’s Hotel. Moreover, I added Industry Average ratios for the Hospitality industry to compare them with Chancellors and Castlefield

Table 1. Financial ratios for the year ending 31.12.2011 [5]. After explaining the meaning of financial ratios I can say that both Hotels are in secure financial situation (see Table 1.). Both Gross Profit ratios are higher than Industry Average, it indicates that Hotels might be overcharging and in long-term consequence they can lose the customers (see Table 1.). Net profit of the Chancellors Hotel is close to Industry Average, what means that Hotel operates efficiently; however, Net Profit of the Castlefield Hotel is too low, what shows inefficiency and shortage of money to invest (see Table 1.). ROCE shows that invested capital is being used very effectively to produce profit in both Hotels; even so, Castlefield Hotel uses its capital twice as better to produce profit as Cancellors Hotel (see Table 1.).

Current ratio shows that Chancellors Hotel almost covers its current liabilities, what means they might not have enough money to pay its debts (see Table 1.). Current ratio of Castlefield Hotel is much better and shows that they can cover current liabilities and invest money in the business (see Table 1.). Acid Test ratio indicates that Castlefield Hotel is pretty much secure, however Chancellors Hotel’s liquid assets could not cover its current liabilities and it means that they are not secure and have financial difficulties (see Table 1.). Stock Turnover Days in both Hotels are higher than Industry Average, what indicates on bad stock control and possible wastage (see Table 1.). Chancellors Hotel has good figures in Debtor Collection Days and Creditor Payment Period comparing with Industry Average; however Castlefield Hotel might have problems with suppliers and might not have enough money to pay other bills because they are not using their advantage to pay its debts in longer time (see Table 1.).

Conclusions and recommendations

To sum up, I can say that Chancellors Hotel is in a secure financial situation, has enough money to invest in future development and would not have any difficulties with suppliers and investors. But still there are some areas to improve. To improve Net Profit I would recommend increase selling prices on 5-10% and lower staff members. Moreover, I recommend hire a good financial manager to improve inefficient management and to lower down cash in the business, thus Current ratio will growth. Generating more cash flow is the best way to improve Acid Test ratio because cash is the most liquid current asset.


[1] Accounting Tools. Net Profit Ratio Last accessed: 22.12.2012 [2] Bell E. The Importance of Financial Ratios. Last accessed: 18.12.2012 [3] Chancellors Hotel. Hotel in Manchester Centre with Parking. Last accessed: 20.12.2012 [4] Chron. The Importance of Working Capital Management in Avoiding Bankruptcy Last accessed: 26.12.2012 [5] FAME Database. Castlefield Hotel Limited Last accessed: 05.01.2013 [6] Investing Answers. Acid-Test Ratio Last accessed: 24.12.2012 [7] Investopedia. Inventory Turnover Last accessed: 27.12.2012 [8] QFinance. Creditor and debtor days Last accessed: 03.01.2013 [9] Ready Ratios. Financial Analysis and Accounting Book of Reference Last accessed: 22.12.2012 [10] Small Business Development Corporation. Profit Margin Ratio’s and Break Even Analysis Last accessed: 22.12.2012

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