Types of Financial Ratios
Types of Financial ratios is done as per the financial aspect of the business which the ratio measures. Also, different types of financial ratios are important for different users. For example, external users like investors use ratios related to Market value and Liquidity. Internal users like employees and Management use Efficiency and Leverage related ratios. Profitability ratios are used by both internal and external users.
There are primarily top 5 types of financial ratios as discussed below –
- Liquidity Ratios
- Leverage Ratios
- Efficiency/Activity Ratios
- Profitability Ratios
- Market value Ratios
Let us discuss each type of financial ratio in detail –
Type #1 – Liquidity Ratios
Liquidity ratios measure the company’s ability to meet current liabilities. It includes the following
Determines a company’s ability to meet short-term liabilities with current assets:
Under these types of financial 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 1 indicates that the company has surplus short term assets in addition to meeting short term obligations.
Acid-Test / Quick Ratio:
Determines a company’s ability to meet short-term liabilities with quick assets:
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 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):
Type #2 – Leverage Financial 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.
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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 ratio 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, higher is the risk. (As there will be a huge outgo on interest)
Debt to Equity Ratio:
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.
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 ratio shows the number of times a company’s operating income can cover its debt obligations:
Type #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 turnover 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:
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 assets of a company can generate sales.
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.
Type #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 Margin is the final profit available for distribution to shareholders.
Return on Equity (ROE):
This types of financial ratio indicate how effectively the shareholder’s money is used by the company.
The higher the ROE ratio, the better is the return to its investors.
Return on Assets (ROA):
The return on assets (ROA) 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 financial 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 Ratio is compared with the market value to determine if it is costly or cheap.
Dividend Yield Ratio:
The dividend yield ratio shows the return on investments if the amount is invested at the current market price.
Earnings Per Share Ratio (EPS):
The earnings per share ratio (EPS) indicates the amount of net income earned for each share outstanding:
The price-earnings ratio 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 types of 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 –