Types of Financial Ratios
Financial ratios are the ratios that are used to analyze the financial statements of the company to evaluate performance where these ratios are applied according to the results required and these ratios are divided into five broad categories which are liquidity ratios, leverage financial ratios, efficiency ratio, profitability ratios, and market value ratios.
List of Top 5 Types of Financial Ratios
- Liquidity Ratios
- Leverage RatiosLeverage RatiosDebt-to-equity, debt-to-capital, debt-to-assets, and debt-to-EBITDA are examples of leverage ratios that are used to determine how much debt a company has taken out against its assets or equity.
- Efficiency/Activity Ratios
- Profitability RatiosProfitability 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.
- Market value Ratios
Let us discuss each of them in detail –
#1 – Liquidity Ratios
Liquidity ratios measure the company’s ability to meet 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.. It includes the following
Determines a company’s ability to meet short-term liabilities with current assets:
Under these types of ratios, a 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 lower than 1 indicates the company may not be able to meet its short term obligations on time. A ratio higher than 1 indicates that the company has surplus short term assetsShort Term AssetsShort term assets (also known as current assets) are the assets that are highly liquid in nature and can be easily sold to realize money from the market. They have a maturity of fewer than 12 months and are highly tradable and marketable in nature. in addition to meeting short term obligations.
Acid-Test / Quick Ratio:
Determines a company’s ability to meet short-term liabilities with quick assetsQuick AssetsQuick Assets are assets that are liquid in nature and can be converted into cash easily by liquidating them in the market. Fixed deposits, liquid funds, marketable securities, bank balances, and so on are examples.:
Quick assets exclude inventory and other current assetsOther Current AssetsOther current assets refer to the category of assets which record all the uncommon and insignificant assets readily convertible into cash and doesn't fit in any common current assets categories like cash & cash equivalents, inventory, trade receivables, etc. 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 RatioCash RatioCash 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. determines a company’s ability to meet short-term liabilities with cash and cash equivalents(CCE):
Operating Cash Flow Ratio:
Determines the times a company can meet current liabilities with the operating cash generated (OCF):
#2 – Leverage Ratios
Under these types of financial ratios, it 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.
This debt ratioDebt RatioThe debt ratio is the division of total debt liabilities to the company's total assets. It represents a company's ability to hold and be in a position to repay the debt if necessary on an urgent basis. Formula = total liabilities/total assets helps to determine the proportion of borrowing in a company’s capital. It indicates how much assets are financed by debt.
If this ratio is low, it indicates the company is in a better position as it is able to meet its requirements out of its own funds. Higher the ratio, the higher is the risk. (As there will be a huge outgo on interest)
Debt to Equity Ratio:
The debt-equity ratioDebt-equity RatioThe debt to equity ratio is a representation of the company's capital structure that determines the proportion of external liabilities to the shareholders' equity. It helps the investors determine the organization's leverage position and risk level. 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.
If this ratio is high, then there is little chance that lenders may finance the company. But if this ratio is low, then the company can resort to external creditors for expansion.
Interest Coverage Ratio:
This types of financial ratio shows the number of times a company’s operating income can cover its interest expenses:
Debt Service Coverage Ratio:
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. shows the number of times a company’s operating income can cover its debt obligations:
#3 – Efficiency / Activity Ratios
Under these types of financial ratios, Activity ratios show the efficiency with which a company utilizes its assets.
Inventory Turnover Ratio:
Inventory turnoverInventory TurnoverInventory Turnover Ratio is a measure to determine the efficiency of a Company concerning its overall inventory management. To calculate the ratio, divide the cost of goods sold by the gross inventory. shows how efficiently the company sells goods at less cost(Investment in inventory).
A higher ratio indicates that the company is able to 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 determines the efficiency of a company in collecting cash out of credit salesCredit SalesCredit Sales is a transaction type in which the customers/buyers are allowed to pay up for the bought item later on instead of paying at the exact time of purchase. It gives them the required time to collect money & make the payment. made during the year.
A higher ratio indicates higher collections while a lower ratio indicates a lower collection of cash.
Total Assets Turnover Ratio:
This type of financial ratio indicates how quickly total assetsTotal AssetsTotal Assets is the sum of a company's current and noncurrent assets. Total assets also equals to the sum of total liabilities and total shareholder funds. Total Assets = Liabilities + Shareholder Equity of a company can generate sales.
For example, a higher asset turnover ratioAsset Turnover RatioThe asset turnover ratio is the ratio of a company's net sales to total average assets, and it helps determine whether the company generates enough revenue to justify holding a large amount of assets under the company’s balance sheet. 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 indicator to determine the success of the firm. Higher the profitability ratio, better is the company in comparison to other companies with 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 loss.
Gross Profit Margin:
Operating Profit Margin:
Operating profit is calculated by deducting selling, general and administrative expenses from a company’s gross profit amount.
Net Profit Margin
Net Profit MarginNet Profit MarginNet profit margin is the percentage of net income a company derives from its net sales. It indicates the organization's overall profitability after incurring its interest and tax expenses. is the final profit available for distribution to shareholders.
Return on Equity (ROE):
This types of ratio indicate how effectively the shareholder’s money is used by the company.
The higher the ROE ratioROE RatioReturn 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., the better is the return to its investors.
Return on Assets (ROA):
The return on assets (ROA) formula ratio indicates how effectively the company is using its assets to make a profit. The higher the return, the better is the company in effectively using its assets.
#5 – Market Value Ratios
Under these types of ratios, Market value ratios help to evaluate the share price of a company. It gives an indicator to potential and existing investors whether the share price is overvalued or undervalued. It includes the following:
Book Value Per Share Ratio:
Book Value Per Share RatioBook Value Per Share RatioThe book value per share (BVPS) formula evaluates the actual value of the common equity for each outstanding share, excluding the preferred stock value. A higher BVPS compared to the market value per share indicates an overvaluation of stocks and vice-versa. is compared with the market value to determine if it is costly or cheap.
Dividend Yield Ratio:
The dividend yieldDividend YieldDividend yield ratio is the ratio of a company's current dividend to its current share price. It represents the potential return on investment for a given stock. ratio shows the return on investments if the amount is invested at the current market price.
Earnings Per Share Ratio (EPS):
The earnings per shareEarnings Per ShareEarnings 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. ratio (EPS) indicates the amount of net income earned for each share outstanding:
The price-earnings ratioPrice-earnings RatioThe price to earnings (PE) ratio measures the relative value of the corporate stocks, i.e., whether it is undervalued or overvalued. It is calculated as the proportion of the current price per share to the earnings per share. is calculated by dividing the Market price by the EPS. This ratio is compared with other companies in the same industry to see if the market price of the company is overvalued or undervalued.
This has been a Guide to Types of Financial Ratios. Here we discuss 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 –