A financial ratio is used to calculate a company’s financial status or production against other firms. It is a tool used by investors to analyze and gain information about the finance of a company’s history or the entire business sector.
The theory of financial ratios was made popular by Benjamin Graham, who is popularly known as the fundamental analysis father. Financial ratios help interpret the results and compare with previous years and other companies in the same industry.
Ratio analysis is a useful management tool that will improve your understanding of financial results and trends over time, and provide key indicators of organizational performance. Managers will use ratio analysis to pinpoint strengths and weaknesses from which strategies and initiatives can be formed. Funders may use ratio analysis to measure your results against other organizations or make judgments concerning management effectiveness and mission impact. Let us understand the uses and various types of financial ratios.
Uses of the Financial Ratios
Experts use financial ratios for analysis of the financial situation of the company. These ratios allow for comparison between:
- Same company at two different time periods
- Company and its industry average
These ratios must be benchmarked against something such as the company’s past performance. Only then, it will be useful. These are not useful for companies that belong to different industries or have different capital requirements. These can be expressed in the value of decimals or in percentages. For all ratios, experts take numerical values from income statements, balance sheets, statements of cash flows and sometimes from statements of changes in equity. Let us now learn about each ratio in detail.
Types of Financial Ratios
There are many types of ratios and each one signifies a part of a company’s financial health. These are categorized as:
- Efficiency ratios
- Leverage ratios
- Liquidity ratios
- Profitability ratios
1. Efficiency Ratio
Efficiency or activity financial ratio measures how well the organization is optimizing its assets. Following are the different types of efficiency ratios:
- Asset turnover ratio
- Accounts receivable turnover ratio
- Inventory turnover ratio
- Days sales in inventory ratio
a. Asset Turnover Ratio
In simple words, it measures the ability to generate sales from assets.
Asset turnover ratio = Net sales / Average total assets
This ratio measures the value of the revenue generated in comparison with the average total assets for a fiscal year. Average total assets include the initial and final balance of the company’s assets. It indicates how efficiently the company is using its fixed and current assets for revenue generation. These include current, fixed and intangible assets as well as long term investments.
b. Accounts Receivable Turnover
The accounts receivable turnover is one of the financial ratios for analysis of the number of times a company can turn its receivables into cash over a time period. This ratio is used for measuring the company’s efficiency of collecting on the credit that they provide to their customers.
Receivables turnover ratio = Net credit sales / Average accounts receivable
c. Inventory Turnover Ratio
The inventory ratio indicates the number of times the business sells and replaces the goods during a particular time period. If the inventory turnover ratio is high, it means the goods are selling fast. If this financial ratio is low, then it means that goods are selling slowly indicating that the business is not growing.
Inventory turnover ratio = Cost of goods sold / Average inventor
d. Days Sales in Inventory (DSI)
It is a financial ratio for the analysis of the average number of days that are required by a business for converting its inventory into sales figures. For calculation purposes, the goods considered as ‘work in progress’ (WIP) are included in inventory. This ratio also determines the average days required by the company for converting its resources into cash flows.
DIS= (inventory/cost of goods sold) x number of days
2. Leverage Ratio
The leverage ratio measures whether the company can meet its financial obligations. It indicates at the amount of capital coming from debt. Once you are aware of this amount, you can evaluate whether a company can pay its due debts. It indicates how the assets and business operations of company assets are financed. There are different types of leverage ratios, including the following five:
- Asset-to-Equity= Total Assets / Total Equity
- Debt-to-Assets= Total Debt / Total Assets
- Debt-to-Capital= Today Debt / (Total Debt + Total Equity)
- Debt-to-Equity = Total Debt / Total Equity
- Debt-to-EBITDA = Total Debt / Earnings Before Interest Taxes Depreciation & Amortization (EBITDA)
3. Liquidity Ratios
These are financial ratios that analyses the company’s capability to repay short-term and long-term obligations. Following are the common liquidity ratios:
- Acid-test ratio
- Cash ratio
- Current ratio
- Operating cash flow ratio
a. Acid-test ratio
An acid test or quick ratio is a financial ratio that measures the ability of a company’s short term assets to cover current financial obligations.
Acid-test ratio= (Cash & Cash Equivalents + Accounts Receivables + Market Securities)/ current liabilities
Acid-test ratio= (current assets – inventories)/current liabilities
b. Cash Ratio
Cash or cash asset ratio is a financial ratio for analysis of a company’s capability to pay off short-term debt obligations with either cash or cash equivalents. This is a conservative liquidity ratio that only considers a company’s liquid assets such as cash and cash equivalents.
Cash ratio= cash and cash equivalents/current liabilities
c. Current ratio
Current or Working capital ratio indicates the capability of the business to fulfil its short term obligations due within one year. This is a financial ratio that explains how companies can maximize the liquidity of their current assets to settle payables. It considers the weight of current assets versus current liabilities.
Current ratio = Current assets/current liabilities
d. Operating Cash flows
It measures how efficiently the company can pay off its current liabilities with the cash flow generated from business operations. It indicates how much a company earns from operational activities.
Operating cash flow ratio = Cash flow from operations/current liabilities
4. Profitability Ratios
Profitability ratios are the financial ratios for analysis of the company’s ability to generate profit relative to the following:
- Operating costs
- Balance sheet assets
- Shareholders’ equity during a specific time period
If the profitability ratio is high, the business is considered to be performing well as it is generating profits, revenue and cash flow. Following are the different types of profitability ratios:
- Gross margin ratio
- Return on assets ratio
- Operating Profit Margin
1. Gross Margin Ratio
The gross margin ratio is a ratio that compares the company’s gross margin to its margin. It indicates the amount of profit a company makes after paying the cost of goods sold (COGS).
Gross Margin Ratio = (Revenue – COGS) / Revenue
2. Return on Assets Ratio
It is a metric of investment that measures the profitability of the business by comparing net income to the capital invested in assets. The higher the return, the higher the productive and efficient management in economic resource utilization.
ROA = Net Income / Average Assets
3. Operating Profit Margin
It is a performance ratio that reflects the profit percentage of the company that is produced from operations before reducing taxes and interest charges. This is also known as the (Earnings Before Interest and Tax) EBIT margin.
Operating profit margin = operating profit/ total revenue
Ratio analysis of financial statements benefits all stakeholders in an organisation. It enables comprehensive financial analysis and effective financial management.
Here are some objectives of ratio analysis:
1. To measure profitability: The objective of any business is profitability. Ratio analysis helps to measure values like gross profit ratio, net profit ratio, expense ratio etc., to understand if a business is yielding enough profits or not. A thorough understanding will enable the management to identify problem areas and work on them.
2. To assess operational efficiency: Some ratios are used to assess how efficiently a company manages its resources and assets. Efficient use of assets and resources is critical for avoiding meaningless expenses. Mismanagement of assets can be measured using turnover ratios and efficiency ratios.
3. To ensure easy cash availability: A company may need cash any time, and it has to ensure that some assets can be liquidated quickly to make up for the requirement. The quick and current ratios of the company determine a firm’s liquidity. Maintaining these ratios at an optimum level ensures the organisation has adequate liquidity.
4. To determine the financial health of the organisation: Ratio analysis of a company can also help to determine its long-term solvency. These ratios include debt-equity ratio, leverage ratio. Etc. and help the management to assess the situation and take steps to avoid liquidation. They indicate if there is a strain on the assets or if there is enough leverage in case of a financial crisis.
5. To compare the performance: Knowing the fiscal position and financial well-being of the company is important to understand the company’s performance. It also helps to determine the actions management needs to take to improve performance. The ratios are compared to industry standards and previous years’ ratios to assess the progress.
These ratios and others will aid your understanding of a business, but they should always be looked at in totality rather than focusing on just one or two ratios. Financial analysis using ratios is just one step in the process of investing in a company’s stock. Be sure to also research management and read what they’re saying about a business. Sometimes the things that can’t be easily measured matter most for the future of a business.
Frequently Asked Questions?
Ratio analysis becomes important as it portrays a more accurate picture of the actual state of the operations of a company. For example, a company that has made a 1000 crores revenue in the last quarter, might have a negative net profit margin, or might be in a liquidity crunch, due to high debtors. Just static numbers on their own may not fully explain how a company is performing.
Financial ratios are created to calculate the numerical values which are available in the financial statements. These ratios help in asserting the financial position of a company.
The Different Types of Financial Statements are Profit & Loss Statement, Balance sheet & Cash Flow Statement.
The four types of financial ratios are liquidity Ratios, Leverage Ratios, Efficiency Ratio, Profitability Ratio.