We all studied Ratios at school. Eventhough we didn’t understand the realtime application of the concept back then, Ratios are pretty much a useful thing to analyse efficency when it comes to finance.
Ever wondered how some investors and traders are always sure about what stocks or companies to put money in? How do they do it? First things first, they research about the company’s fundamentals, and for that they do a thorough financial ratio analysis.
Now what is a financial ratio, and how to do a financial ratio analysis, is what we are going to focus in this article. So keep reading to become an informed investor.
Content:
- What is Financial Ratio?
- Importance of Financial Ratio
- Types of Financial Ratios
- How to use Financial Ratios?
- Pros and Cons of using Financial Ratios
- Quick Summary
What is Financial Ratio?
To better understand a business, financial ratios are calculated using data found in financial statements. The data on a company’s financial statements (income statement, balance sheet, and cash flow statement) are used to undertake quantitative analysis and assess liquidity, growth, leverage, profitability, margins, rates of return, value, and other factors.
Importance of Financial Ratio
1. Track company performance
Financial ratios are calculated on a period-by-period basis, and their evolution through time is monitored, with the goal of spotting patterns. As an example, if a company’s debt-to-asset ratio keeps rising, that could mean it’s taking on too much debt and could put it at risk of default.
2. Make comparative judgments regarding company performance
By comparing a company’s financial ratios to those of its major competitors, you can find out if the company is doing better or less than the average in its sector. By comparing the return on assets of different companies, for example, an analyst or investor can figure out which company is using its assets in the best way.
Financial ratios are used by both people outside and inside the company:
- External Users: Financial analysts, individual investors, creditors, competitors, tax authorities, government regulators, and people who watch the industry
- Internal Users: The owners, the management team, and the workers
Types of Financial Ratios
Liquidity Ratios
Liquidity ratios are a type of financial ratio that shows how well a company can pay its short-term and long-term debts. Among the most common liquidity ratios are:
- Current Ratio= Current Assets/Current Liabilities
The current ratio shows how well a company’s current assets can cover its short-term debts.
- Acid-Test Ratio= (Current Assets – Inventories)/Current Liabilities
The acid-test ratio shows how quickly a company can pay off its short-term debts with its short-term assets.
- Cash Ratio= Cash And Cash Equivalents/Current Liabilities
The cash ratio shows how well a company can pay off its short-term debts with cash and cash equivalent assets.
- Operating Cash Flow Ratio= Operating Cash Flow/Current Liabilities
The operating cash flow ratio shows how many times a company can pay off its current debts with the cash it brings in during a certain time period.
Leverage Financial Ratios
Leverage ratios show how much of a company’s capital comes from debt. Leverage financial ratios are used to figure out how much debt a company has. The following are some common leverage ratios:
- Debt Ratio= Total Liabilities/Total Assets
The debt ratio determines how much of a company’s assets are derived from debt.
- Debt To Equity Ratio= Total Liabilities/Shareholder’s Equity
The debt-to-equity ratio compares the total amount of debt and financial liabilities to the amount of equity owned by shareholders.
- Interest Coverage Ratio= Operating Income/Interest Expenses
The interest coverage ratio shows how easy it is for a company to pay its interest costs.
- Debt Service Coverage Ratio= Operating Income/Total Debt Service
The debt service coverage ratio shows how easy it is for a business to pay its debts.
Efficiency Ratios
Efficiency ratios, which are also called activity financial ratios, are used to figure out how well a company is using its assets and resources. Among the most common efficiency ratios are:
- Asset Turnover Ratio= Net Sales/Average Total Assets
The asset turnover ratio shows how well a company can turn its assets into sales.
- Inventory Turnover Ratio= Cost Of Goods Sold/Average Inventory
The inventory turnover ratio shows how many times a company’s stock is sold and replaced over a certain time period.
- Receivables Turnover Ratio= Net Credit Sales/Average Accounts Receivable
The accounts receivable turnover ratio calculates how often a company can convert receivables into cash in a particular period.
- Days Sales In Inventory Ratio= 365 Days/Inventory Turnover Ratio
The days sales in inventory ratio calculates the average number of days a business keeps inventory before selling it to customers.
Profitability Ratios
Profitability ratios assess a firm’s ability to create income in relation to its revenue, balance sheet assets, operating costs, and equity. The following are examples of common profitability financial ratios:
- Gross Margin Ratio= Gross Profit/Net Sales
The gross margin ratio compares a company’s gross profit to its net sales to find out how much money it makes after paying for its cost of goods sold.
- Operating Margin Ratio= Operating Income/Net Sales
The operating margin ratio measures a company’s operational efficiency by comparing operating income to net sales.
- Return On Assets Ratio= Net Income/Total Assets
The return on assets ratio shows how well a company is making money by using its assets.
- Return On Equity Ratio= Net Income/Shareholder’s Equity
The return on equity ratio shows how well a company is making money by using its equity.
Market Value Ratios
Market value ratios are used to figure out how much a share of stock is worth. Among the most common market value ratios are:
- Book Value Per Share Ratio= (Shareholder’s Equity – Preferred Equity)/Total Common Shares Outstanding
The book value per share ratio figures out how much each share of a company is worth based on the equity that shareholders have access to.
- Dividend Yield Ratio=Dividend Per Share/Share Price
The dividend yield ratio compares the dividends paid to shareholders to the market value of each share.
- Earnings Per Share Ratio= Net Earnings/Total Shares Outstanding
The earnings per share ratio shows how much net income a company makes for each share it has on the market.
- Price-Earnings Ratio= Share Price/Earnings Per Share
The price-earnings ratio compares the price of a company’s shares to how much money each share brings in.
How to use Financial Ratios?
Financial ratio analysis is a way to get information from a company’s financial statements that can’t be seen by just looking at the statements themselves.
Most of the time, ratios are worked out for a quarter or a year. Then, ratios for other companies in the same industry should be looked up. It’s important to compare.
A financial manager can only figure out how well a company is doing by comparing its financial ratios to other times and to the ratios of other companies in the same sector. Based on these calculations and comparisons, financial managers can get a good idea of how well a company is doing.
One calculation of a ratio doesn’t tell you much on its own. For example, if a company’s debt-to-asset ratio for one time period is 50%, that doesn’t tell management anything useful unless they compare it to other times, especially if the ratio was much lower or higher in the past.
In this case, the debt-to-asset ratio shows that 50% of the company’s assets are paid for by debt. A financial manager or investor wouldn’t know if that’s good or bad unless he compared it to the same ratio from the company’s past or to the ratios of its competitors.
Pros and Cons of using Financial Ratios
| Pros | Cons |
| Helpful for setting high-performance goals | Large companies with many divisions can only use it by division. |
| Useful for smaller companies with a narrow focus or parts of larger companies | When inflation is high, financial data is skewed and can’t be used for ratio analysis |
| Useful for comparing the performance of a company over time | Companies can hide the truth and “window dress” their financial statements. |
| This is helpful for comparing companies in a cross-sectional or industry analysis. | Due to time distortion, it is not useful for seasonal or cyclical businesses. |
Quick Summary
- Financial ratios are calculated using data found in financial statements. The data on a company’s financial statements (income statement, balance sheet, and cash flow statement) are used to undertake quantitative analysis and assess liquidity, growth, leverage, profitability, margins, rates of return, value, and other factors.
- Importance of Financial Ratio
- Track company performance
- Make comparative judgments regarding company performance
- Liquidity Ratios
Liquidity ratios are a type of financial ratio that shows how well a company can pay its short-term and long-term debts. Among the most common liquidity ratios are:
- Current Ratio= Current Assets/Current Liabilities
- Acid-Test Ratio= (Current Assets – Inventories)/Current Liabilities
- Cash Ratio= Cash And Cash Equivalents/Current Liabilities
- Operating Cash Flow Ratio= Operating Cash Flow/Current Liabilities
- Leverage Financial Ratios
Leverage ratios show how much of a company’s capital comes from debt. That is, leverage financial ratios are used to figure out how much debt a company has. The following are some common leverage ratios:
- Debt Ratio= Total Liabilities/Total Assets
- Debt To Equity Ratio= Total Liabilities/Shareholder’s Equity
- Interest Coverage Ratio= Operating Income/Interest Expenses
- Debt Service Coverage Ratio= Operating Income/Total Debt Service
- Efficiency Ratios
Efficiency ratios, which are also called activity financial ratios, are used to figure out how well a company is using its assets and resources. Among the most common efficiency ratios are:
- Asset Turnover Ratio= Net Sales/Average Total Assets
- Inventory Turnover Ratio= Cost Of Goods Sold/Average Inventory
- Receivables Turnover Ratio= Net Credit Sales/Average Accounts Receivable
- Days Sales In Inventory Ratio= 365 Days/Inventory Turnover Ratio
- Profitability Ratios
Profitability ratios assess a firm’s ability to create income in relation to its revenue, balance sheet assets, operating costs, and equity. The following are examples of common profitability financial ratios:
- Gross Margin Ratio= Gross Profit/Net Sales
- Operating Margin Ratio= Operating Income/Net Sales
- Return On Assets Ratio= Net Income/Total Assets
- Return On Equity Ratio= Net Income/Shareholder’s Equity
- Market Value Ratios
Market value ratios are used to figure out how much a share of stock is worth. Among the most common market value ratios are:
- Book Value Per Share Ratio= (Shareholder’s Equity – Preferred Equity)/Total Common Shares Outstanding
- Dividend Yield Ratio= Dividend Per Share/Share Price
- Earnings Per Share Ratio= Net Earnings/Total Shares Outstanding
- Price-Earnings Ratio= Share Price/Earnings Per Share
