Financial Ratios are computed using data available from the company’s financial statements. These financial ratios are a useful way of expressing relationships between financial accounts, one quantity in relation to another and between expected relationships from one point in time to another.
For instance in the case of current ratio, we compare current assets to current liabilities. If the current ratio is 2 or 2:1, it means we have twice as much current assets to take care of short term obligations.
Ratio analysis helps to evaluate past performance, assesses current financial position of a company to gain insights for projecting future results. Financial analysts use ratios as an indicator of some aspects of a company’s performance. These are very effective in selecting investments and in predicting financial distress.
For instance, if a financial analyst wants to know which of two companies are more profitable? Then profitability ratios such as operating margin, net profit margin can help by expressing profit relative to revenue.
To know more, you can read our article on how net profit margin is used to analyse a company’s profitability.
Financial ratios do help to assess a company’s growth potential and risk, however, they can not be used alone to directly value a company or its securities. Entire operation of the company must be examined by using fundamental analysis.
A variety of financial ratios is used by financial analysts. These are used as a great way to gain an understanding of a company’s potential for success.
Financial Statements and Ratios
Over the years, analysts have developed a number of financial ratios to analyse a company’s strength and weakness by reading and comparing line items of financial statements.
The main purpose for which a company prepares financial statements is to provide information to interested parties. These interested users include investors, shareholders, lenders, creditors, government and credit rating agencies.
Every company prepares and publishes its financial statements for stakeholders.
Three most commonly used financial statements to analyse company’s strength and weakness are followings:
These techniques of analysing a company’s strength and weakness are part of fundamental analysis.
Why to use financial ratios
Anyone can read a company’s financial statements, but it’s not how to read, it’s about how to analyse and interpret line items of these financial statements by comparing with previous years and different standards.
Financial ratios are one of the best tools that was developed to start analysing these statements. These tools will give you real insight into the numbers reported by the company in its income statement, balance sheet and statement of cash flow.
By analysing company’s financial ratios, you will get answer to following questions;
- Does the business make profitable use of the capital available to it?
- Is the business efficiently using its resources?
- how well the business is equipped to meet its current obligations?
- how the capital is contributed to the business? Out of total how much is contributed by owners and how much is contributed by outsiders?
- What return the organisation is able to generate on shareholders investment?
Financial ratios are considered the backbone of fundamental analysis. You can compare one company with another by using financial ratios as it gives you a common basis for comparison instead of solely emphasising a single period’s line items.
Financial ratios can be divided in a number of ways. To analyse business performance and financial position of an organisation, we have grouped it to following categories:
- Profitability indicator
- Activity or operating performance
- Liquidity measurement
- Solvency
- Valuation
Financial ratios to know company’s profitability
Profitability ratios measure the company’s ability to generate profit from sales and resources. High revenue doesn’t necessarily translate into high earnings or high dividends.
It examines productivity of a company from multiple angles using different scenarios. One of the most popular profitability ratios is net profit margin. This financial ratio compares a company’s net profit to revenue.
Management’s performance is tracked more closely as earnings or profitability. To analyse a company’s profitability, the following financial ratios can help you know how the management has performed during the period.
- Gross margin
- Net profit margin
- Operating profit margin (OPM)
- Return on equity
- Return on assets
All these tools are used to compare profit margin at different points of time with revenue from business to find out how profitable the company is.
These financial ratios measure how much profit a company is getting from its resources and how well the company is doing at making money .
Liquidity measurement
Company’s efficiency can be measured by assessing the liquidity position and by figuring out how well a company is managing its affairs. It determines the ability of a company to generate cash and to pay its obligations when they come due.
Liquidity ratios measure a company’s ability to meet short term obligations. In other words, it measures how quickly a company can repay its debts.
Liquidity ratios give investors information on a company’s operational efficiency. A higher liquidity ratio is favourable as it represents the number of times current assets can cover current liabilities. Therefore a higher liquidity ratio indicates more short term liquidity and good financial health.
Following important ratios can be used to assess management’s liquidity:
- Acid test or Quick Ratio
- Current Ratio
- Cash Ratio
Activity or operating performance indicators
Activity Ratios measures how effectively a company performs its day to day business such as accounts receivable and inventory, and how efficiently it manages its various assets.
To know company’s efficiency, you can use following financial tools:
Turnover ratio indicates how much a company gets out of its assets. These are also known as efficiency ratios as they indicate how well a company is managing its resources.
Solvency indicator
Solvency ratios are used to analyse a company’s ability to meet long term obligations. It’s also known as leverage ratios. Debt to assets and debt to equity are two important ratios often used for a quick check of a company’s debt levels.
To evaluate a company which has debt, you can use the following two solvency analysis tools to find out how the company is covering its cost of debt and will it be able to survive in the long run.
Coverage ratio is a measure of a company’s ability to meet a particular obligations such as interest, rent and any other fixed obligations.
If the company has a high interest coverage ratio, then the company is generating enough profit to repay its debt obligations. This means higher interest coverage is better, as it has the ability to meet its longer-term obligations.
Finding value of a stock by using valuation ratios
Financial ratios measure the quantity of an asset or flow. Also known as multiples. These valuation ratios are often referred to by the media. These financial ratios incorporated the current market price of the company’s stock into the calculation.
To find the value of a stock and the actual price to buy and sell, you can take help of following valuation ratios.
For instance, price to book (P/B) compares a company’s current stock market price to its book value.
A higher price to book value indicates investors are paying more for the company’s assets. A stock with a high price to book value is called growth stock.
Similarly if it’s less, then investors are not paying more for the book value of the company. A stock with less price to book is called value stock.
These financial ratios can help you to find all information you need to analyse a financial statement. Understanding its impact can give you greater confidence in your investment decision.
As stated above, each category of financial ratios are useful in measuring multiple aspects of the business. These financial ratios are essential to solid fundamental analysis.
In cross sectional or trend analysis, financial ratios of a company are compared with major competitors and with prior periods. The main purpose is to understand the cause of divergence between a company’s ratios and those of the industry.
Here is how financial ratios are calculated;
| Financial Ratios | Formula |
| Activity ratios | |
| Inventory turnover | Cost of goods sold / Average inventory |
| Days of inventory on hand (DOH) | Number of days in period / Inventory turnover |
| Receivables turnover | Revenue / Average receivables |
| Days of sales outstanding (DSO) | Number of days in period / Receivables turnover |
| Payables turnover | Purchases / Average trade payables |
| Number of days of payables | Number of days in period / Payables turnover |
| Working capital turnover | Revenue / Average working capital |
| Fixed asset turnover | Revenue / Average net fixed assets |
| Total asset turnover | Revenue / Average total assets |
| Liquidity ratios | |
| Current ratio | Current assets / Current liabilities |
| Quick ratio | (Cash + short-term marketableInvestments + receivables) / Current liabilities |
| Cash ratio | (Cash short-term marketableinvestments) / Current liabilities |
| Defensive interval ratio | (Cash + short-term marketableInvestments + receivables) / Daily cash expenditures |
| Cash conversion cycle (netoperating cycle) | DOH + DSO – number of daysof payables |
| Solvency ratios | |
| Debt-to-assets ratio | Total debt / Total assets |
| Debt-to-capital ratio | Total debt / Total shareholders’ equity |
| Debt-to-equity ratio | Total debt / Total shareholders’ equity |
| Financial leverage ratio | Average total assets / Average total equity |
| Interest coverage | Earnings Before Interest and Tax / Interest expenses |
| Fixed charge coverage | (EBIT + lease payments) / (Interest payments + lease payments) |
| Profitability ratios | |
| Gross profit margin | Gross profit / Revenue |
| Operating profit margin | Operating income / Revenue |
| Net profit margin | Net income / Revenue |
| ROA | Net income / Average total assets |
| ROE | Net income / Average total equity |
| Valuation ratios | |
| P/E | Price per share / Earnings per share |
| P/CF | Price per share / Cash flow per share |
| P/S | Price per share / Sales per share |
| P/B | Price per share / Book value per share |
| EPS | (Net income minus preferreddividends) / Weighted average number of ordinary shares outstanding |
| Cash flow per share | Cash flow from operations / Average number of shares outstanding |
| Dividends per share | Common dividends declared / Weighted average number of ordinary shares outstanding |
| Dividend payout ratio | Common share dividends / Net income attributable to common shares |
Financial ratios are used in combination to gain a complete picture of a company. All these financial ratios can be computed using financial data available in the company’s income statement, balance sheet and statement of cash flows.
Every figure required to calculate these financial ratios can be found in a company’s financial statements. These can help investors to evaluate stocks within an industry and to compare to its own historical data. By calculating and understanding these financial ratios gives you better confidence in your investment decisions.
Frequently Asked Questions (FAQs)
Which financial ratios you should know and how to use them
Generally, financial ratios fall into one of five categories, including:
To analyze profitability and management effectiveness, you can use return on assets, return on equity and return on invested capital.
For efficiency analysis, use Accounts receivable turnover, Inventory turnover, Accounts payable turnover.
To evaluate financial conditions of a company, Debt to equity, Quick ratio, and Interest coverage ratio can be used. For valuation, Price-to-book ratio, Dividend yield, price to earnings and Earnings yield can be used.
