What Are Financial Ratios?
Financial ratios are the indicators of the financial performance of companies. Different financial ratios indicate the company’s results, financial risks, and working efficiency, like the liquidity ratio, asset turnover ratio, operating profitability ratios, business risk ratios, financial risk ratios, stability ratios, etc.
They are the best tools used by the company’s management and stakeholders to understand its financial health, risk appetite, overall performance, and growth levels. They act as guidance while making financial and investment-related decisions because they provide an insight into the current conditions and future opportunities.
Table of contents
- What Are Financial Ratios?
- Financial ratios are a crucial indicator of a company’s overall financial performance and health.
- These ratios offer valuable insights into various aspects of the company’s operations, including its financial results, potential risks, and operational efficiency. They cover important areas such as liquidity, asset turnover, operating profitability, business risk, financial risk, and stability.
- An efficiency ratio of 100% or higher is regarded as a positive sign, indicating that the company is effectively utilizing its resources to generate revenue and maximize its operational efficiency.
Financial Ratios Explained
The financial ratios are a perfect quantitative metric that is used to measure the financial condition of the company. It is a process that is used to bring out the current picture of the business as well as make forecasts related to the future possibilities for growth and expansion.
These financial key ratios are extremely useful for management decision making and stakeholders understanding. They are easy to interpret as well as calculate, making them very a very important tool for company evaluation. The management, investors, analysts, etc can use analysis of financial ratios for measuring profitability, efficiency, solvency and financial position.
This makes stakeholders take informed decisions. In this article we will learn about some important and commonly used financial ratios that provide insight into the various aspects of the company’s performance. These ratios are also used in combination with each other so as to get a better understanding of the and a comprehensive view of the company’s financial health. However, along with the ratios, it is equally important to factor in the market performance, economic conditions, company or industry specific factors, etc. Otherwise the information will lead to incomplete analysis.
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Financial Ratios Explained in Video
Below are the types and list of financial ratios that are very widely used in every business. Let us identify them:
- Current Ratio
- Quick Ratio
- Absolute Liquidity Ratio
- Cash Ratio
- Inventory Turnover RatioInventory Turnover RatioInventory Turnover Ratio measures how fast the company replaces a current batch of inventories and transforms them into sales. Higher ratio indicates that the company’s product is in high demand and sells quickly, resulting in lower inventory management costs and more earnings.
- Receivables Turnover Ratio
- Capital Turnover Ratio
- Asset Turnover Ratio
- Net Working Capital Ratio
- Cash Conversion Cycle
- Earnings Margin
- Return on Investment
- Return on Equity
- Earnings Per Share
- Operating Leverage
- Financial leverage
- Total Leverage
- Debt-Equity Ratio
- Interest Coverage Ratio
- Debt Service Coverage Ratio
- Fixed Asset Ratio
- Current Asset to Fixed Asset
- Proprietary Ratio
- Fixed Interest Cover
- Fixed Dividend Cover
- Capacity Ratio
- Activity Ratio
- Efficiency Ratio
Given below are some important formula that the company management and stakeholders use for analysis of financial ratios and company evaluation. They are divided as per the type of analysis they perform. Let us study them in details.
Liquidity Ratio Analysis
The first type of financial ratio analysis is the liquidity ratio. It aims to determine a business’s ability to meet its financial obligations during the short term and maintain its short-term debt-paying ability. One can calculate the liquidity ratio in multiple ways. They are as follows: –
#1 – Current Ratio
The current ratioCurrent RatioThe current ratio is a liquidity ratio that measures how efficiently a company can repay it' short-term loans within a year. Current ratio = current assets/current liabilities is a working capital ratio or banker’s ratio. The current ratio expresses the relationship between a current asset to current liabilitiesCurrent LiabilitiesCurrent Liabilities are the payables which are likely to settled within twelve months of reporting. They're usually salaries payable, expense payable, short term loans etc..
Formula = Current Assets / Current Liabilities
One can compare a company’s current ratio with the past current ratio; this will help to determine if the current ratio is high or low at this period in time.
The ratio of 1 is ideal; if current assetsCurrent AssetsCurrent assets refer to those short-term assets which can be efficiently utilized for business operations, sold for immediate cash or liquidated within a year. It comprises inventory, cash, cash equivalents, marketable securities, accounts receivable, etc. are twice a current liability. No issue will be in repaying liability. However, if the ratio is less than 2, repayment of liability will be difficult and affect the work.
#2 – Acid Test Ratio/ Quick Ratio
Generally, one can use the current ratio to evaluate an enterprise’s short-term solvencySolvencySolvency of a company means its ability to meet the long term financial commitments, continue its operation in the foreseeable future and achieve long term growth. It indicates that the entity will conduct its business with ease. or liquidityLiquidityLiquidity is the ease of converting assets or securities into cash. position. Still, it is often desirable to know a firm’s more immediate status or instant debt-paying ability than that indicated by the current ratio for this acid test financial ratio. That is because it relates the most liquid assetsLiquid AssetsLiquid Assets are the business assets that can be converted into cash within a short period, such as cash, marketable securities, and money market instruments. They are recorded on the asset side of the company's balance sheet. to current liabilities.
Acid Test Formula = (Current Assets -Inventory)/(Current Liability)
One can write the quick ratioQuick RatioThe quick ratio, also known as the acid test ratio, measures the ability of the company to repay the short-term debts with the help of the most liquid assets. It is calculated by adding total cash and equivalents, accounts receivable, and the marketable investments of the company, then dividing it by its total current liabilities. as: –
Quick Ratio Formula = Quick Assets / Current Liabilities
Quick Ratio Formula = Quick Assets / Quick Liabilities
#3 – Absolute Liquidity Ratio
Absolute liquidity is also among another financial key ratios that helps to calculate actual liquidity. And for that, inventory and receivables are excluded from current assets. In addition, some assets ban to understand better liquidity. Ideally, the ratio should be 1:2.
Absolute Liquidity = Cash + Marketable SecuritiesMarketable SecuritiesMarketable securities are liquid assets that can be converted into cash quickly and are classified as current assets on a company's balance sheet. Commercial Paper, Treasury notes, and other money market instruments are included in it. + Net Receivable and Debtors
#4 – Cash Ratio
The Cash ratio is useful Cash Ratio Is UsefulCash Ratio is calculated by dividing the total cash and the cash equivalents of the company by total current liabilities. It indicates how quickly a business can pay off its short term liabilities using the non-current assets. for a company undergoing financial trouble.
Cash Ratio Formula = Cash + Marketable Securities / Current Liability
If the ratio is high, then it reflects the underutilization of resources. If the ratio is low, it can lead to a problem in the repayment of bills.
Turnover Ratio Analysis
The second type of financial ratio analysis is the turnover ratio. The turnover ratio is also known as the activity ratio. This ratio indicates the efficiency with which an enterprise’s resources utilize. Again, the financial ratio can be calculated separately for each asset typeAsset TypeAssets are the resources owned by individuals, companies, or governments expected to generate future cash flows over a long period. There are broadly three types of asset distribution: 1. Based on convertibility (current and non-current assets), 2. Physical existence (tangible and intangible assets), 3. Usage (operating and non-operating assets).
The following are financial ratios commonly calculated:-
#5 – Inventory Turnover Ratio
This financial ratio measures the relative inventory size and influences the cash available to pay liabilities.
Inventory Turnover Ratio Formula = Cost of Goods Sold / Average Inventory
#6 – Debtors or Receivable Turnover Ratio
The receivable turnover ratio shows how often the receivable turns into cash.
Receivable Turnover Ratio Formula = Net Credit Sales / Average Accounts Receivable
#7 – Capital Turnover Ratio
The capital turnoverCapital TurnoverCapital turnover determines the organization's capital utilization efficiency and is calculated as a ratio of total annual turnover divided by the total amount of stockholder's equity. The higher the ratio, the better the utilization of the capital employed. ratio measures the effectiveness with which a firm uses its financial resources.
Capital Turnover Ratio Formula = Net Sales (Cost of Goods Sold) / Capital Employed
#8 – Asset Turnover Ratio
This financial ratio reveals the number of times the net tangible assetsNet Tangible AssetsNet Tangible Assets is the value derived from the company's total assets minus all intangible assets. Net Tangible Assets per share is calculated by dividing the net assets by the outstanding number of equity shares. turns over during a year. The higher the ratio better it is.
Asset Turnover Ratio Formula = Turnover / Net Tangible Assets
#9 – Net Working Capital Turnover Ratio
This financial ratio indicates whether or not working capital has been utilized effectively in sales. Net Working CapitalNet Working CapitalThe Net Working Capital (NWC) is the difference between the total current assets and total current liabilities. A positive net working capital indicates that a company has a large number of assets, while a negative one indicates that the company has a large number of liabilities. signifies the excess of current assets over current liabilities.
Net Working Capital Turnover Ratio Formula = Net Sales / Net Working Capital
#10 – Cash Conversion Cycle
The Cash Conversion CycleCash Conversion CycleThe Cash Conversion Cycle (CCC) is a ratio analysis measure to evaluate the number of days or time a company converts its inventory and other inputs into cash. It considers the days inventory outstanding, days sales outstanding and days payable outstanding for computation. is the total time taken by the firm to convert its cash outflows into cash inflows (returns).
Cash Conversion Cycle Formula = Receivable Days + Inventory Days – Payable Days
Operating Profitability Ratio Analysis
The third type of financial key ratios used in financial ratio analysis is the operating profitability ratio. The profitability ratio helps to measure a company’s profitability through this efficiency of business activityBusiness ActivityBusiness activities refer to the activities performed by businesses to make a profit and ensure business continuity. . The following are the important profitability ratiosImportant Profitability RatiosProfitability ratios help in evaluating the ability of a company to generate income against the expenses. These ratios represent the financial viability of the company in various terms.:-
#11 – Earning Margin
It is the ratio of net incomeNet IncomeNet income for individuals and businesses refers to the amount of money left after subtracting direct and indirect expenses, taxes, and other deductions from their gross income. The income statement typically mentions it as the last line item, reflecting the profits made by an entity. to turnover expressed in percentage. It refers to the final net profit used.
Earning Margin formula = Net Income / Turnover * 100
#12 – Return on Capital Employed or Return On the Investment
This financial ratio measures profitability concerning the total capital employed in a business enterprise.
Return on Investment formula = Profit Before Interest and Tax / Total Capital Employed
#13 – Return On Equity
Return on equityReturn On EquityReturn on Equity (ROE) represents financial performance of a company. It is calculated as the net income divided by the shareholders equity. ROE signifies the efficiency in which the company is using assets to make profit. derives by dividing net income by shareholder’s equity. It provides a return that management realizes from the shareholder’s equity.
Return on Equity Formula = Profit After Taxation – Preference Dividends / Ordinary Shareholder’s Fund * 100
#14 – Earnings Per Share
EPSEPSEarnings Per Share (EPS) is a key financial metric that investors use to assess a company's performance and profitability before investing. It is calculated by dividing total earnings or total net income by the total number of outstanding shares. The higher the earnings per share (EPS), the more profitable the company is. derives by dividing the company’s profit by the total number of shares outstanding. It means profit or net earnings.
Earnings Per Share Formula = Earnings After Taxation – Preference Dividends / Number of Ordinary Shares
Before investing, the investor uses all the above ratios to maximize profit and analyze risk. He can easily compare and predict a company’s future growth through ratios. It also simplifies the financial statementFinancial StatementFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels..
Business Risk Ratios
The fourth type of financial ratio analysis is the business risk ratio. Here, we measure how sensitive the company’s earnings are concerning its fixed costs and the assumed debt on the balance sheetBalance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company..
#15 – Operating Leverage
Operating leverageOperating LeverageOperating Leverage is an accounting metric that helps the analyst in analyzing how a company’s operations are related to the company’s revenues. The ratio gives details about how much of a revenue increase will the company have with a specific percentage of sales increase – which puts the predictability of sales into the forefront. is the percentage change in operating profit relative to sales. It measures how sensitive the operating income is to the change in revenues. The greater the use of fixed costsFixed CostsFixed Cost refers to the cost or expense that is not affected by any decrease or increase in the number of units produced or sold over a short-term horizon. It is the type of cost which is not dependent on the business activity., the more significant the impact of a change in sales on a company’s operating income.
Operating Leverage Formula = % Change in EBIT / % Change in Sales
#16 – Financial Leverage
Financial leverage is the percentage change in net profit relative to operating profit, and it measures how sensitive the net income is to the change in operating income. Financial leverage primarily originates from the company’s financing decisions (debt usage).
Financial Leverage Formula = % Change in Net Income / % Change in EBIT
#17 – Total Leverage
Total leverage is the percentage change in net profit relative to its sales. The total leverage measures how sensitive the net income is to the change in sales.
Total Leverage Formula = % Change in Net Profit / % Change in Sales
Financial Risk Ratio Analysis
The fifth type of financial ratioType Of Financial RatioFinancial ratios are of five types which are liquidity ratios, leverage financial ratios, efficiency ratio, profitability ratios, and market value ratios. These ratios analyze the financial performance of a company for an accounting period. is the financial riskFinancial RiskFinancial risk refers to the risk of losing funds and assets with the possibility of not being able to pay off the debt taken from creditors, banks and financial institutions. A firm may face this due to incompetent business decisions and practices, eventually leading to bankruptcy. ratio. Here, we measure how leveraged the company is and placed concerning its debt repayment capacity.
#18 – Debt Equity Ratio
Debt Equity Formula = Long Term Debts / Shareholder’s Fund
It helps to measure the extent of equityEquityEquity refers to investor’s ownership of a company representing the amount they would receive after liquidating assets and paying off the liabilities and debts. It is the difference between the assets and liabilities shown on a company's balance sheet. to repay debt. One may use it for long-term calculations.
#19 – Interest Coverage Ratio Analysis
This financial ratio signifies the ability of the firm to pay interest on the assumed debt.
Interest Coverage Formula = EBITDA / Interest Expense
- Higher interest coverage ratios imply the greater ability of the firm to pay off its interests.
- If interest coverage is less than 1, then EBITDA is insufficient to pay off interest, implying finding other ways to arrange funds.
#20 – Debt Service Coverage Ratio (DSCR)
The Debt Service Coverage RatioDebt Service Coverage RatioDebt service coverage (DSCR) is the ratio of net operating income to total debt service that determines whether a company's net income is sufficient to cover its debt obligations. It is used to calculate the loanable amount to a corporation during commercial real estate lending. tells us whether the operating income is sufficient to pay off all obligations related to debt in a year.
Debt Service Coverage Formula = Operating Income / Debt Service
Operating IncomeOperating IncomeOperating Income, also known as EBIT or Recurring Profit, is an important yardstick of profit measurement and reflects the operating performance of the business. It doesn’t take into consideration non-operating gains or losses suffered by businesses, the impact of financial leverage, and tax factors. It is calculated as the difference between Gross Profit and Operating Expenses of the business. is nothing but EBIT
Debt Service is Principal Payments + Interest Payments + LeasePayments + Interest Payments + LeaseLease payments are the payments where the lessee under the lease agreement has to pay monthly fixed rental for using the asset to the lessor. The ownership of such an asset is generally taken back by the owner after the lease term expiration. Payments
- A DSCR of less than 1.0 implies that the operating cash flowsCash FlowsCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. are insufficient for debt servicing, indicating negative cash flows.
The sixth type of financial ratio analysis is the stability ratio. It is used with a long-term vision and to check the company’s stability in the long run. One can calculate this type of ratio analysis in multiple ways. They are as follows: –
#21 – Fixed Asset Ratio
This ratio one may use to know whether the company is having good fun or not to meet the long-term business requirement.
Fixed Asset Ratio Formula = Fixed Assets / Capital Employed
The ideal ratio is 0.67. If the ratio is less than 1, one can use it to purchase fixed assetsFixed AssetsFixed assets are assets that are held for the long term and are not expected to be converted into cash in a short period of time. Plant and machinery, land and buildings, furniture, computers, copyright, and vehicles are all examples..
#22 – Ratio to Current Assets to Fixed Assets
Ratio to Current Assets to Fixed Assets = Current Assets / Fixed Assets
IIf the ratio increases, profit increases and reflects the business expansion. If the ratio decreases, trading is loose.
#23 – Proprietary Ratio
The proprietary ratio is the ratio of shareholder fundsShareholder FundsShareholder Fund (SF) is the fund available to stakeholders after all liabilities have been met in the event of a company’s liquidation. to total tangible assetsTangible AssetsTangible assets are assets with significant value and are available in physical form. It means any asset that can be touched and felt could be labeled a tangible one with a long-term valuation.; it discusses a company’s financial strength. Ideally, the ratio should be 1:3.
Proprietary Ratio Formula = Shareholder Fund / Total Tangible Assets
The seventh type of financial ratio analysis is the coverage ratioCoverage RatioThe coverage ratio indicates the company's ability to meet all of its obligations, including debt, leasing payments, and dividends, over any specified period. A higher coverage ratio indicates that the business is a stronger position to repay its debt. Popular coverage ratios include debt, interest, asset, and cash coverage.. This ratio analysis Ratio AnalysisRatio analysis is the quantitative interpretation of the company's financial performance. It provides valuable information about the organization's profitability, solvency, operational efficiency and liquidity positions as represented by the financial statements. one may use to calculate dividends needed to pay to investors or interest to the lender. The higher the cover, the better it is. One may estimate it in the below ways: –
#24 – Fixed Interest Cover
It measures business profitability and its ability to repay the loanLoanA loan is a vehicle for credit in which a lender will give a sum of money to a borrower or borrowing entity in exchange for future repayment..
Fixed Interest Cover Formula = Net Profit Before Interest and Tax / Interest Charge
#25 – Fixed Dividend Cover
It helps to measure the dividends needed to pay the investor.
Fixed Dividend Cover Formula = Net Profit Before Interest and Tax / Dividend on Preference Share
Control Ratio Analysis
The eighth type of financial ratio analysis is the control ratio. It controls things by management. For example, this ratio analysis helps management check favorable or unfavorable performance.
#26 – Capacity Ratio
For this type of ratio analysis, one can use the formula below for the same.
Capacity Ratio Formula = Actual Hour Worked / Budgeted Hour * 100
#27 – Activity Ratio
For calculating a measure of activity below, one may use the formula:
Activity Ratio Formula = Standard Hours for Actual Production / Budgeted Standard Hour * 100
#28 – Efficiency Ratio
For calculating productivity, below is the formula:
Efficiency Ratio Formula = Standard Hours for Actual Production / Actual Hour Worked * 100
If it is 100% or more, it is considered favorable. But, if it is less than 100%, it is unfavorable.
Let us understand the concepts of calculating financial ratios with the help of some suitable examples.
For calculation of current ratio, let us assume the following for ABC ltd:
Cash – $30 million
Inventory – $25 million
Short term debts – $10 million
Accounts payable – $14 million
If we try to calculate the current ratio, it will be as follows:
Current ratio = Current Asset/Current Liability = (30+25)/ (10+14) = 55/24 = 2.29
In this example, let us see how calculating financial ratios can be used for comparison.
Suppose Black Ltd and White Ltd are two pharmaceutical companies operating in the same region. But the inventory turnover ratio of Black Ltd is 25%, whereas that of White Ltd is 30%. From the above data, we can conclude that White Ltd is able to convert its inventory into sales must faster that Black Ltd because its inventory turnover ratio is higher that Black Ltd.
This also proves that White Ltd’s sale is higher, leading to higher revenue, increasing its chance of profit earning and customer base expansion. It also means that less capital is blocked in the form of inventory, which can be used for some other important purpose.
These financial ratios in accounting have a lot of importance in the financial market and provide valuable insight for analysts, investor, management, or anyone who has some interest in the overall performance of the company.
- Assessment – The most important use is the assessment or evaluation of performance, which helps investors or stakeholders take important financial and investment decisions.
- Comparison – The metrics can be successfully used to compare similar companies or businesses in the same industry to understand and identify the relative strength and weakness. This also helps in understanding the competitive position. Trend – The raios help in clarifying trends over a number of years to observe whether the company is improving or not. It indicates any improvement, fall or stability in its overall performance.
- Credit analysis – The method also helps in evaluating the credit condition of the business, which means whether they have the capacity to pay off the debts. High credit worthy companies have the facility of getting loans at lower interest rates and favourable credit terms.
- Problem identification – The financial ratios in accounting provide ways and means to identify problems which hinder the progress of the company. It is necessary to identity the problem areas and take steps to control or mitigate them on time so that they don’t accelerate into sometime negative, thus affecting the image and performance of the company.
- Management decision – The management monitors the performance and identify risk and opportunities for the best interest of the business and stakeholders. These ratios help in tracking progress, setting goals and ultimately enhance business efficiency.
Let us understand the limitations of the process:
- Lack of proper context – They do not take into account the specific context or industry rules and specifications. One ratio may be good for one company but not suitable for another company even though they are in the same industry.
- Past data – They mostly deal with past data which may not reflect the current market condition of strategy changes.
- Variation in accounting methods – The methods of accounting followed in companies vary leading to inconsistency and differences in financial statements and interpretation of ratios.
- Window Dresssing – The management may use the ratios for making the financial statements and reports look good and profitable in order to attract more investors. This is sometimes difficult to detect and harmful for stakeholders.
- Lack of non-financial consideration – The ratios don’t take into account the non-financial factors like, management skills and quality, technological advancements, etc.
- The inflation effect – The effect of inflation over time on these financial ratios cannot be ruled out. Inflation affects the assets and liabilities over time.
Frequently Asked Questions (FAQs)
Financial ratios are important because they provide valuable insights into a company’s financial performance, profitability, liquidity, and overall health. They help investors, analysts, and stakeholders make informed decisions about investments, assess risk, and evaluate a business’s financial stability and efficiency.
Important financial ratios for investors include profitability ratios (such as return on equity and net profit margin), liquidity ratios (like current ratio and quick ratio), and solvency ratios (such as debt-to-equity ratio). These ratios help investors gauge the company’s profitability, ability to meet short-term obligations, and long-term financial stability.
Financial ratios have limitations. They rely on historical financial data and may not capture future trends or market changes. Ratios can vary across industries, making comparing them within the same sector crucial. Additionally, ratios are based on accounting principles and may not reflect a company’s true economic value or performance. It’s important to consider other qualitative and quantitative factors alongside financial ratios for a comprehensive analysis.
This article is a guide to what are Financial Ratios. We explain its formula and types, importance, limitations along with examples. You may learn more about ratio analysis from the following articles: –
- Working Capital Turnover Ratio FormulaWorking Capital Turnover Ratio FormulaWorking Capital Turnover Ratio helps in determining that how efficiently the company is using its working capital (current assets – current liabilities) in the business and is calculated by diving the net sales of the company during the period with the average working capital during the same period.
- Cash Ratio Formula
- Calculate Operating Expense Ratio
- Limitations of Ratio AnalysisLimitations Of Ratio AnalysisThere are some limitations to ratio analysis, such as the fact that it only considers quantitative aspects and completely ignores qualitative aspects, that it does not consider the reasons for fluctuation of amounts, which could lead to inaccurate results, and that it only shows the comparison or trend.