Types of Financial Ratios

Updated on May 15, 2024
Article byWallstreetmojo Team
Edited byAaron Crowe
Reviewed byDheeraj Vaidya, CFA, FRM

Types of Financial Ratios

Financial ratios are the ratios used to analyze the company’s financial statements to evaluate performance. These ratios are applied according to the results required, and these ratios are divided into five broad categories: liquidity ratios, leverage financial ratios, efficiency ratios, profitability ratios, and market value ratios.

List of Top 5 Types of Financial Ratios

  1. Liquidity Ratios
  2. Leverage Ratios
  3. Efficiency/Activity Ratios
  4. Profitability Ratios
  5. Market value Ratios

Let us discuss each of them in detail –

Types of Financial Ratios

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Video Explanation of Financial Ratios

 

#1 – Liquidity Ratios

Liquidity ratios measure the company’s ability to meet current liabilities. It includes the following.

Current Ratio
Liquidity - Current Ratio

Determines a company’s ability to meet short-term liabilities with current assets:

Current Ratio = Current Assets / Current Liabilities

Under these types of ratios, a current ratio lower than 1 indicates the company may not be able to meet its short term obligations on time. A ratio higher than one indicates that the company has short-term surplus short term assets and meets short-term obligations.

Acid-Test / Quick Ratio:
Liquidity - Quick Ratio

Determines a company’s ability to meet short-term liabilities with quick assets:

Quick Ratio = (CA – Inventories) / CL

Quick assets exclude inventory and other current assets which are not readily convertible into cash.

If it is higher than 1, then the company has surplus cash. But if it is lower, it may indicate that the company relies too heavily on inventory to meet its obligations.

Cash Ratio
nestle-vs-hershey-vs-danone-cash-ratios-1

Cash Ratio determines a company’s ability to meet short-term liabilities with cash and cash equivalents(CCE):

Cash ratio = CCE / Current Liabilities

Operating Cash Flow Ratio:

Determines the times a company can meet current liabilities with the operating cash generated (OCF):

Operating Cash Flow Ratio = OCF / Current Liabilities

#2 – Leverage Ratios

Under these types of financial ratios, how much a company depends on its borrowing for its operations. Hence it is important for bankers and investors who wish to invest in the company.

A high leverage ratio increases a company’s exposure to risk and company downturns, but in turn, also comes the potential for higher returns.

Debt Ratio
Debt Ratio - Colgate Ratio Analysis

This debt ratio helps to determine the proportion of borrowing in a company’s capital. In addition, it indicates how much assets are financed by debt.

Debt ratio = Total Debt / Total Assets

If this ratio, in addition, is low, it indicates the company is in a better position as it can meet its requirements out of its funds. The higher the ratio, the higher is the risk. (As there will be a huge outgo on interest)

Debt to Equity Ratio:
Debt to Equity Ratio - Ratio Analysis Colgate

The debt-equity ratio measures the relation between total liabilities and total equity. It shows how much vendors and financial creditors have committed to the company compared to what the shareholders have committed.

Debt Equity Ratio = Total Liabilities / Shareholders Equity

If this ratio is high, then there is little chance that lenders may finance the company. But if this ratio is low, the company can resort to external creditors for expansion.

Interest Coverage Ratio:
interest-coverage-ratio

This type of financial ratio shows the number of times a company’s operating income can cover its interest expenses:

Interest Coverage Ratio = Income from Operation/ Interest Expense

Debt Service Coverage Ratio:
Seadrill DSCR calculation - 4

The debt service coverage ratio shows the number of times a company’s operating income can cover its debt obligations:

Debt Service Coverage Ratio = Income from Operation / Total Debt

#3 – Efficiency / Activity Ratios

Under these types of financial ratios, Activity ratios show how a company utilizes its assets.

Inventory Turnover Ratio:
Inventory Turnover Ratio Analysis - Colgate

Inventory turnover shows how efficiently the company sells goods at less cost(Investment in inventory).

Inventory Turnover ratio = Cost Of Goods Sold / Inventory

A higher ratio indicates that the company can convert inventory to sales quickly. A low inventory turnover rate indicates that the company is carrying obsolete items.

Accounts Receivable Turnover Ratio:
Accounts Receivables Turnover Ratio

Accounts Receivables turnover determines the efficiency of a company in collecting cash out of Credit sales made during the year.

Accounts Receivable Turnover Ratio = Credit Sales / Accounts Receivable

A higher ratio indicates higher collections, while a lower ratio indicates a lower cash collection.

Total Assets Turnover Ratio:
wallmart-asset-turnover-v1

This type of financial ratio indicates how quickly total assets of a company can generate sales.

Asset Turnover Ratio = Net Sales / Total Assets

For example, a higher asset turnover ratio indicates the machinery used is efficient. A lower ratio shows the machinery is old and not able to generate sales quickly.

#4 – Profitability Ratios

Most used indicators to determine the success of the firm. The higher the profitability ratio, the better the company is compared to other companies with a lower profitability ratio.

Margin is more important than the value in absolute terms. For example, consider a company with a profit of $1M. But if the margin is just 1%, then a slight increase in cost might result in a loss.

Gross Profit Margin:
Gross Profit margin - Ratio Analysis colgate

Gross Profit Margin = Gross Profit (Sales – Direct Expenses like Material, Labour, Fuel, and Power, etc) / Sales

Operating Profit Margin:
Operating Profit Margin - Ratio Analysis - Colgate

Operating profit is calculated by deducting selling, general and administrative expenses from a company’s gross profit amount.

Operating Profit Margin = Operating profit / Net Sales

Net Profit Margin
Net Profit Margin - Ratio Analysis Colgate

Net Profit Margin is the final profit available for distribution to shareholders.

Net Profit Margin = Net Profit (Operating Profit – Interest – Tax) / Net Sales
Return on Equity (ROE):
Pepsi vs Coca Cola ROE

This ratio type indicates how effectively the company uses the shareholder’s money.

Return on Equity = Net income / Equity

The higher the ROE ratio, the better is the return to its investors.

Return on Assets (ROA):
box-negative-return-on-assets

The return on assets (ROA) formula ratio indicates how effectively the company uses its assets to make a profit. The higher the return, the better the company in effectively using its assets.

Return on Assets = Net income / Total Assets

#5 – Market Value Ratios

Under these types of ratios, Market value ratios help evaluate the share price of a company. It indicates to potential and existing investors whether the share price is overvalued or undervalued. It includes the following:

Book Value Per Share Ratio:
Google book value per share

Book Value Per Share Ratio is compared with the market value to determine if it is costly or cheap.

Book Value Per Share Ratio = Shareholder’s Equity / Total Shares Outstanding
 Dividend Yield Ratio:
Dividend Yield Ratio

The dividend yield ratio shows the return on investments if the amount is invested at the current market price.

Dividend Yield Ratio = Dividend per Share (DPS) / Share Price
Earnings Per Share Ratio (EPS):

The earnings per share ratio (EPS) indicates the amount of net income earned for each share outstanding:

EPS = Earnings for the Period (Net Income) / Number of Shares Outstanding
Price-Earnings Ratio:
PE Ratio Valuation

The price-earnings ratio is calculated by dividing the Market price by the EPS. Then, this ratio is compared with other companies in the same industry to see if the company’s market price is overvalued or undervalued.

Price-Earnings Ratio = Share Price / EPS

Recommended Articles

This has been a Guide to Types of Financial Ratios. Here we discuss the Top 5 financial ratios, including liquidity ratios, leverage ratios, activity ratios, profitability ratios, and market value ratios. You can learn more about financing from the following articles –

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