Financial Ratios
Financial Ratio is the use of financial numbers to get important information about a company. The numbers found on a company’s financial statements – balance sheets, income statements, and cash flow statements – are used to perform quantitative analysis and assess a company’s liquidity, leverage, growth, margin, profitability, rate of return, valuation, and more.
In this article, you will learn about:
Profitability Ratio, Liquidity Ratio, Solvency Ratio, Activity Ratio (Efficiency Ratio), Leverage Ratio, Market Value Ratio, Valuation Ratio and Growth Ratios
In accounting, a ratio is a coefficient or a percentage generally calculated between two functional masses of the balance sheet or the income statement. Ratios are used to measure profitability, cost structure, productivity, solvency, liquidity, financial balance, etc.
Why are they important?
The financial ratios help companies understand different aspects of their finances. For instance, the profitability ratios show if the company is making enough money. Liquidity ratios help to see if there’s enough cash to pay off bills. These ratios provide a picture of how a company is doing financially.
They are widely used by investors, creditors, and financial analysts to make informed decisions about investments, loans, and business strategies.
Read also: Accounting Formulas | Definition, Calculation and Utility
Financial ratios can be classified into many groups depending on the needs of the company
By analyzing these ratios, businesses can identify areas where they’re doing well and areas where they need to improve. They can also compare their ratios to industry benchmarks to see how they stack up against their competitors.
In short, financial ratios are like financial checkups for businesses. They help companies stay on track, make informed decisions, and achieve their long-term financial goals. Here are some examples:
Profitability Ratio: Shows how well a company makes money
Profitability ratios measure a company’s ability to generate income relative to revenue, balance sheet assets, operating costs, and equity. For Formulas, Examples, Questions, Answers: Profitability Ratio
Profitability Ratios: These ratios measure a company’s ability to generate profits from its operations.
Examples include:
- Profit Margin: Net income divided by net sales
- Gross Profit Margin: Gross profit divided by net sales
Liquidity Ratio: Measures a company’s ability to pay its bills
Liquidity ratios are financial ratios that measure a company’s ability to repay both short- and long-term obligations. For Formulas, Examples, Questions, Answers: Liquidity Ratio
Liquidity Ratios: These ratios assess a company’s ability to meet its short-term obligations, such as paying off current debts.
Examples include:
- Current Ratio: Current assets divided by current liabilities
- Quick Ratio: (Current assets – Inventory) divided by current liabilities
Solvency Ratio: Checks if a company can handle its debts
A solvency ratio is a performance metric that helps us examine a company’s financial health. In particular, it enables us to determine whether the company can meet its financial obligations in the long term. For Formulas, Examples, Questions, Answers: Solvency Ratio
Solvency Ratios: These ratios evaluate a company’s ability to meet its long-term obligations, such as paying off long-term debts.
Examples include:
- Debt-to-Equity Ratio: Total liabilities divided by total equity
- Debt-to-Asset Ratio: Total liabilities divided by total assets
Activity Ratio (Efficiency Ratio): Measures how well a company uses its resources
Efficiency ratios, also known as activity financial ratios, are used to measure how well a company is utilizing its assets and resources. For Formulas, Examples, Questions, Answers: Activity Ratio (Efficiency Ratio)
Activity Ratio (Efficiency Ratio): These ratios measure how effectively a company utilizes its resources, such as inventory and accounts receivable.
Examples include:
- Inventory Turnover Ratio: Cost of goods sold divided by average inventory
- Accounts Receivable Turnover Ratio: Net credit sales divided by average accounts receivable
Leverage Ratio: Checks how much a company uses debt to run its business
Leverage ratio in finance is a general term for any technique intended to multiply profits and losses. Common leverage techniques are debt, the purchase of long-term assets and derivatives (such as warrants). For Formulas, Examples, Questions, Answers: Leverage Ratio
Leverage Ratio: These ratios assess a company’s use of debt to finance its operations.
Examples include:
- Debt-to-Capital Ratio: Total debt divided by total capital (debt + equity)
- Debt-to-EBITDA Ratio: Total debt divided by earnings before interest, taxes, depreciation, and amortization (EBITDA)
Market Value Ratio: Helps in understanding the company’s stock value
Market value ratios are used to evaluate the share price of a company’s stock. For Formulas, Examples, Questions, Answers: Market Value Ratio
Market Value Ratio: These ratios compare a company’s stock price to its financial performance.
Examples include:
- Price-to-Earnings Ratio (P/E Ratio): Market price per share divided by earnings per share (EPS)
- Price-to-Book Ratio (P/B Ratio): Market price per share divided by book value per share
Valuation Ratio and Growth Ratios: Shows the worth of a company compared to its earnings or other financial numbers.
A valuation ratio shows the relationship between the market value of a company or its equity and some fundamental financial metric (e.g., earnings). The point of a valuation ratio is to show the price you are paying for some stream of earnings, revenue, or cash flow (or other financial metric). For Formulas, Examples, Questions, Answers: Valuation Ratio and Growth Ratios
Valuation Ratio and Growth Ratios: These ratios assess a company’s long-term growth prospects.
Examples include:
- Price-to-Sales Ratio (P/S Ratio): Market price per share divided by sales per share
- PEG Ratio: Price-to-earnings (P/E) ratio divided by earnings growth rate
Growth Ratios:
- Revenue Growth Rate: Measures the percentage change in a company’s revenue over a period.
- Earnings Growth Rate: Measures the percentage change in a company’s earnings per share (EPS) over a period.
- Dividend Growth Rate: Measures the percentage change in a company’s dividend payout per share over a period.
Cash Flow Ratios:
- Free Cash Flow (FCF): Measures a company’s cash flow available for discretionary purposes, such as dividends, share buybacks, or debt repayment.
- Operating Cash Flow (OCF): Measures a company’s cash flow generated from its core business operations.
- Capital Expenditures (CapEx): Represent the investments a company makes in acquiring or upgrading its fixed
Coverage Ratios: It assess a company’s ability to meet its financial obligations: debt payments, interest expenses, and dividend payments
Examples include:
Debt Service Coverage Ratio (DSCR): Measures a company’s ability to meet debt obligations. Formula: DSCR = Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) / Total Debt Service
Return Ratios: Unveiling a Company’s Profitability and Efficiency
Return Ratios:
Return on Equity (ROE): Shows how effectively a company uses shareholders’ equity to generate profits. Formula: ROE = Net Income / Shareholders’ Equity
Cash Ratio or Acid Test Ratio: Assessing Short-Term Financial Strength
Cash Ratio: The most stringent measure of liquidity, excluding both inventory and prepaid expenses from current assets.
Formula: ((Current Assets – Inventory – Prepaid Expenses) / Current Liabilities)
Calculation: For example, if a company’s current assets are $500,000, its inventory is $200,000, its prepaid expenses are $50,000, and its current liabilities are $300,000, then its cash ratio is 0.80.
Working Capital Turnover Ratio: It measures how efficiently a company manages its working capital to generate sales
Working Capital Turnover Ratio: Measures how efficiently a company manages its working capital, which is the difference between current assets and current liabilities.
Formula: (Net Credit Sales / Average Working Capital)
Calculation: For example, if a company’s net credit sales are $1,000,000 per year and its average working capital is $100,000, then its working capital turnover ratio is 10.
Sources: PinterPandai, The Balance Small Business, Wikipedia, Corporate Finance Institute
Photo credit: Piqsels (CC0 Public Domain)
Financial Risk Management Unveiled: A Deep Dive into Strategies and Solutions