Types of Financial Ratios

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

  1. Liquidity Ratios
  2. 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.read more
  3. Efficiency/Activity Ratios
  4. 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.read more
  5. Market value Ratios

Let us discuss each of them in detail –

Types of Financial Ratios

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#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.read more. 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 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 read more 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.read more in addition to meeting short term obligations.

Acid-Test / Quick Ratio:
Liquidity - 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.read more:

Quick Ratio = (CA – Inventories) / CL

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.read more 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

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.read more 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, 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.

Debt Ratio
Debt Ratio - Colgate Ratio Analysis

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 assetsread more helps to determine the proportion of borrowing in a company’s capital. It indicates how much assets are financed by debt.

Debt ratio = Total Debt / Total Assets

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:
Debt to Equity Ratio - Ratio Analysis Colgate

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. read more 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:
Seadrill DSCR calculation - 4

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.read more 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 the efficiency with which a company utilizes its assets.

Inventory Turnover Ratio:
Inventory Turnover Ratio Analysis - Colgate

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. read more 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 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. read more 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 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 Equityread more of a company can generate sales.

Asset Turnover Ratio = Net Sales / Total Assets

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.read more 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:
Gross Profit margin - Ratio Analysis colgate
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.

Net Profit Margin
Net Profit Margin - Ratio Analysis Colgate

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.read more 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 types of ratio indicate how effectively the shareholder’s money is used by the company.

Return on Equity = Net income / Equity

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.read more, 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.

Return on Assets = Net income / Total 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:
Google book value per share

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.read more 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 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.read more 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 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.read more 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 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. read more 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.

Price-Earnings Ratio = Share Price / EPS

Recommended Articles

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 –

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