Meaning and Types of Financial Ratios

Financial ratio analysis refers to the methods used to evaluate the financial performance of a company by analyzing their liquidity, profitability, efficiency, and leverage using the company’s financial statements such as the statement of profit and loss and the balance sheet. It compares line-item data from the balance sheet or the income statement with an intention of revealing insights about the company’s liquidity, leverage, efficiency and profitability. Financial ratios can be used to compare a company’s performance with the performance of other companies in the industry, or to compare current with past performance.

Types of Financial Ratios

There are several financial ratios which can be used to analyze the financial performance of a company. These ratios are categorized into five major types: liquidity ratios, leverage ratios, efficiency ratios, profitability ratios, and market value ratios.

1) Liquidity Ratios

These are financial ratios that are used to measure the company’s ability to pay off its financial obligations. Liquidity ratios include:

Current Ratio

Current ratios are used to measure the company’s ability to pay its short term liabilities using current assets. This ratio can be calculated using the following formula:

Current ratio = Current assets/Current liabilities

The current ratio uses information from the balance sheet. A higher current ratio indicates that a company has more current assets than current liabilities, which means that the company can easily pay off its short term liabilities using existing current assets. Current assets are those assets that can be converted into cash within one year, such as cash or inventory. A current of at least 2 is preferable since the company can pay off its current liabilities two times over. A current ratio of 2 means that the company’s current assets are double the current liabilities. A current ratio of less than 1 means that the company’s current assets are less than current liabilities; hence it cannot be able to fully pay off its current liabilities using current assets.

Acid-test Ratio

The acid-test ratio refers to a financial ratio that measures the ability of a firm to pay off its short-term liabilities using quick assets, or assets that can be easily turned into cash. The formula for calculating an acid-test ratio is:

Acid-test ratio = (Current assets – Inventories)/Current liabilities

Inventories are subtracted in the formula because they are not easily converted into cash. The acid-test ratio of greater than 1.5 is preferable because the company has more liquid assets to pay off financial obligations as they fall due. The higher the acid-test ratio, the higher the liquidity of the firm.

Cash Ratio

Cash ratio refers to the measure of the company’s ability to pay off its short term liabilities using cash and cash equivalents. This financial ratio can be calculated using the following formula:

Cash ratio = Cash and Cash equivalents/Current Liabilities

A high cash ratio indicates that the company can be able to pay off its current liabilities using cash in hand and cash in bank.

2) Leverage Ratios

This type of financial ratio is used to calculate a company’s leverage, or debt level compared to equity. Leverage ratios are also called solvency ratios; they compare a firm’s debt levels with its equity, earnings, and assets. There are several types of leverage ratios including:

Debt Ratio

The debt ratio refers to the measure of a company’s assets that are funded by debt. It is calculated using the following formula:

Debt ratio = Total liabilities/Total assets

If the debt ratio is greater than 1, it means that the company has more liabilities than assets, which shows a high leverage or high debt level. In this case, decision makers will avoid borrowing additional funds because the company is already in huge debts.

Debt-to-Equity Ratio

It is a financial ratio that evaluates a company’s financial leverage by dividing its liabilities by shareholder equity. It tells you the borrowing patterns of your company and if your company is borrowing too much. If the value is between zero and one, we can say that the company has safe margins. The formula for calculating debt-to-equity ratio is:

            Debt to equity ratio = Total liabilities / Shareholder’s equity

Interest Coverage Ratio

The interest coverage ratio shows how easily a company can pay its interest expenses. It is calculated using the following formula:

Interest coverage ratio = Operating income / Interest expenses

3) Efficiency Ratios: Efficiency ratios are ratios that are used to measure how well a company is using its assets to  increase their earnings.

Asset turnover ratio

The asset turnover ratio measures the ability of a firm to generate sales using its assets. It determines the company’s efficiency by comparing assets to sales as shown in the formula below:

Asset turnover ratio = Net sales/Average total assets

The asset turnover ratio indicates how well a company is utilizing its resources to generate revenue. A higher ratio shows that the company is able to utilize its assets more efficiently to generate revenue.

Inventory Turnover Ratio

The inventory turnover ratio is the measure of the number of times that a company is able to sell its inventory within a specific time. It is calculated using the following formula:

Inventory turnover ratio = Cost of goods sold/Average inventory

A higher the ratio indicates that the company is able to sell its inventory faster, or is able to manage its inventory well in relation to the cost of sales. A low inventory turnover ratio might be a sign of weak sales or excessive inventory, also known as overstocking.

Accounts Receivable Turnover Ratio

The accounts receivable turnover ratio measures how many times a company can turn receivables into cash over a given period:

Receivables turnover ratio = Net credit sales/Average accounts receivable

A high value indicates that the company is able to turn its receivables into cash faster, or is able to collect its debts faster

Days sales inventory ratio

This ratio calculates the number of days that a company can hold on before selling its inventory to customers. The formula for calculating the days sales inventory ratio is shown below:

Days sales in inventory ratio = 365 days / Inventory turnover ratio

A larger number indicates that the company takes longer to convert stock into sales.

4) Profitability Ratio

These are the ratios that are used to calculate the firm’s ability to generate income compared to its revenue, assets, operating costs, and equity. Some of the profitability ratios include:

Gross Margin Ratio

A gross margin ratio is a type of profitability ratio that measures profit margins of a company by comparing gross profits with net sales. It shows the amount of profits that a firm generates after paying off its cost of sales. The formula for calculating gross profit ratio is shown below:

Gross margin ratio = Gross profit/Net sales

A higher gross profit margin indicates that the company is able to generate more sales at lower costs to make profits. The aim of every firm is to increase sales while minimizing the cost of goods sold.

Operating Margin Ratio

The operating margin ratio measures profitability of a firm by comparing the operating income of the company to net sales. This ratio determines the ability of a firm to generate revenue from its operations for every shilling of sales made. It is calculated using the following formula:

Operating margin ratio = Operating income/Net sales

A large operating margin ratio shows that the company returns more of its sales as profits, meaning that operations are run more efficiently to make profits.

Return on Assets Ratio (RAO)

The return on assets ratio measures how efficiently a company is using its assets to generate profit. This ratio is calculated using the following formula:

Return on assets ratio = Net income/Total assets

The ROA figure gives investors an idea of how effective the company is in converting the money it invests into net income. A higher return on assets indicates that the company is able to generate more income with fewer assets; this indicates proper or efficient utilization of assets to generate income.

Return on Equity Ratio

The return on equity (ROE) is a ratio that measures the ability of the firm to earn profits from its equity capital. This ratio can be calculated using the following formula:

Return on equity ratio = Net income/Shareholder’s equity

Return on equity is often used by investors to see whether their share contributions are properly utilized to generate profits. A higher return on investment indicates that the company is efficient in converting equity capital into profits.

5) Market Value Ratios

Market value ratios are used to evaluate the share price of a company’s stock. It is a type of financial ratio that measures how effective a firm is in creating value for shareholders through share prices. If the share price rises, it means higher value for the investor. Common market value ratios include the following:

Book Value per Share Ratio

The book value per share ratio is a type of market value ratio that is used to measure the value of each share of a company in the market. This ratio is calculated by dividing the total amount of shareholders’ equity by the number of outstanding shares.

Book value per share ratio = (Shareholder’s equity – Preferred equity) / Total common shares outstanding

This ratio provides a benchmark to check if the market value of each share is high or low, which can then be analyzed to make buying and selling decisions. A high book value per share ratio indicates that the true share value is high, giving investors the confidence to hold their investments or buy more shares.

Dividend Yield Ratio

The dividend yield ratio is the measure of the dividend amount that is attributed to shareholders, relative to the market value per share. This ratio can be calculated using the following formula:

Dividend yield ratio = Dividend per share/Share price

In financial ratio analysis, this ratio tells us the percentage of a company’s share price that it pays out in dividends each year. For example, if a company’s share price is $10 and it pays dividends of $0.5, the dividend yield will be 0.5/10 = 5%. A high dividend yield ratio indicates that the company’s shares yield more dividends for shareholders.

Earnings per Share Ratio

The earnings per share ratio refers to a type for market value ratio which measures the amount of net income that is earned for every outstanding share. This ratio is calculated by dividing the net earnings by the total number of shares outstanding.

Earnings per share ratio = Net earnings / Total shares outstanding

Earnings per Share indicates the company’s profitability by showing how much money a business makes for each share of its stock. A higher EPS indicates that the company is profitable.

Price-to-Earnings Ratio

The price-to-earnings ratio is a type of market value ratio that compares the share price with the earnings per share.

Price-earnings ratio = Share price/Earnings per share

By and large, the price-to-earnings ratio indicates the amount of money that an investor can expect to invest in a company in order to receive $1 of that company’s earnings. A higher P/E ratio indicates that the investor has to put more money into shares to get more earnings.

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