Financial ratios are decision making tools used by different parties to determine the performance of a business. They are important in determining how profitable an entity is by comparing different information from financial statements. This research paper is going to look at some of the ratios and their role. It is also going to look at the performance of the Hartford hospital based on its financial ratios for the past three years.
Financial ratios are used to evaluate the performance of an organization. Through trend analysis, it is possible to determine whether a firm is performing well or poorly over time. This helps in making strategic decisions which improves performance. They are also used in forecasting and making budgetary allocations. For instance, they can be used to determine whether the amount of cash held by a business is adequate. The other role of these ratios is to compare the firm’s performance with the performance of its competitors and the general industry. The ratios are used by both internal and external parties such as managers, creditors and potential investors. Financial ratios are also used to determine the operating efficiency of a business as well as determining its solvency (Capper, Ginter & Swayne, 2002).
Categories of financial ratios:
- Profitability ratios: These ratios are used to determine how profitable a business would be. They show how efficiently a firm uses its assets in relation to the business size. The main profitability ratios are the return on assets, return on invested capital, return on equity and net profit margin ratio. The return on assets shows the relationship between the after tax profit of a firm and the total assets held by the company. Return on investment gives the effectiveness of a certain investment or group of investments. Return on equity gives the level of profitability based on shareholder’s investments. The net profit margin ratio on the other hand gives a comparison between net profit after tax and revenue. The gross profit to sales ratio is a profitability ratio which gives the relationship between the gross profit and sales of a firm. It is used to determine how efficient the firm’s pricing policies are (Cleverley, Cleverley & Song, 2011).
- Liquidity ratios: This group of ratios is used to show how easily a company is able to pay for its short term debt. A high ratio shows that the company is able to repay such debt on time. The current ratio is a liquidity ratio which shows the relationship between current assets and liabilities. The acid test ratio shows the ability and speed with which current assets of a firm can be converted into cash (Capper et al. 2002).
- Leverage ratios: they are also referred to as capital structure ratios and they show the amount invested by long term creditors. The debt equity ratio is one of the leverage ratios which show by how much liabilities can be paid using the prevailing amount of debt. Total debt on the other hand shows how a company can pay its debt using the amount owed by debtors and borrowed funds (Cleverley et al. 2011).
- Activity ratios: These are ratios concerned with the management of a firm’s assets. Average collection period ratio shows the ease and speed with which debt is converted into cash. The working capital turnover ratio indicates the number of times within a period; working capital is used in carrying out transactions (Priest, 1982). 5. Market value ratios: These are ratios that help to determine the performance of a firm within the industry at large. They include earnings per share, dividend yield and price earnings ratio. Earnings per share gives the investor information about how much earnings they are to receive for each share held in a company. Dividend yield shows the amount of dividends paid out by a company in relation to the price of such shares. Price earnings ratio on the other hand is a market value ratio which compares the share price of a share to the earnings received from the share (Priest, 1982).
The following table shows some of the financial ratios for Hartford hospital calculated from the hospital’s financial statements for the years ended 30th September 2008,2009 and 2010.Because the hospital’s objective is not profit making, only a limited number of financial ratios can be calculated due to the absence of a profit and loss statement.
|Current ratio||Current assets/current liability||1.56||1.51||1.66||1.58||1|
|Quick ratio||Cash & cash equivalent + Net receivable/ Current liability||1.07:1||1.08:1||1.20:1||1.12||1:1|
|Current asset turnover ratio||Total revenue/current assets||4.10||4.16||4.19||4.15||5|
|Days in accounts receivable||Net accounts receivable/Net revenue x 365||55.71||58.33||54.62||56.22||50|
|Average payment period||Current liability/operating expenses –depreciation x 365||58.72||61.40||55.75||58.62||60|
Compared to the national norms of financial ratios, the hospital’s performance is relatively good. Given the average current and quick ratios are both greater than one; it means that the hospital is able to pay for its short term liabilities as and when they fall due. The values should however be reduced so that less money is tied in cash. The hospital should therefore divert some of its idle cash into long term investments through which it can to earn interest. The firm’s current assets turn over ratios for the three years are lower than the industrial norm. The assets of the hospital therefore need to be utilized more effectively. Those assets that the hospital does not use should be disposed off.
The average days in accounts receivable are too many for the hospital industry. This is an indication of poor collection of payments for medical services provided on credit. The hospital should put in place policies that ensure all debt is paid for within 50 days. This ratio can lead to a cash shortage thereby forcing the hospital to borrow funds. The average payment period for the hospital indicates that the hospital is in a good liquidity position as it is able to take care of its short term liabilities as they fall due. It should however be reduced further so that the hospital can be able to enjoy discounts on its purchases.
Given the importance of financial ratios within and out of an organization, it is important for them to be calculated properly. If well used and interpreted, they can give a firm a competitive edge within the industry in which it operates. The ratios help managers in making important decisions such as credit period. Organizations should ensure that such ratios are always maintained within the recommended range.
Capper, S., Ginter, P., & Swayne, L. (2002). Public health leadership & management: cases and context. Thousand Oaks, Calif: Sage Publications.
Cleverley, W., Cleverley, O., & Song, P. (2011). Essentials of health care finance. Sudbury, Mass: Jones & Bartlett Learning. Priest, S. (1982). Managing hospital information systems. Rockville, Md: Aspen Systems Corp.