Introduction to Financial Ratio

In this article, we will discuss on List of Financial Ratios. Financial ratios are the ratio between various measures given on the financial statements such as sales, net income, total assets and liabilities and so on which are calculated periodically to analyze the performance of a company among its peers or over time and understand what it can do better to improve its performance.

There are various aspects that the company, management, investors and the board of directors need to look at for investment or management purposes. These ratios help in determining what decisions need to be taken strategically or from an investment point of view. These ratios also help in pointing out what is an area of improvement and how the company is performing in comparison with its competitors and itself over time.

Types of Financial Ratios

There are various kinds of ratios:

1. Profitability Ratios

Profit arises when revenues and incomes are greater than the costs and expenses, therefore these ratios suggest how well the company is managing its expenses and how much profit is it generating from the given level of revenue. There are various ratios that fall under this umbrella:

Gross Profit Margin = Gross Profit / Net Sales
Operating Margin = Operating Income / Net Sales
Net Profit Margin = Net Profit / Net Sales
Return on Equity = Net Profit / Shareholder’s Equity

The shareholder’s equity can be an end of the year figure or an average figure, as per the need of the analysis

Return on Assets = Net Profit / Total Assets

The total assets can be an end of the year figure or an average figure, as per the need of the analysis

2. Liquidity Ratios

These ratios measure the amount of liquidity available within the company, for example, the amount of assets that can be quickly converted to cash or is in the form of cash and cash equivalents. There are various ratios that fall under this umbrella:

Popular Course in this category

Business Valuation Training (14 Courses)14 Online Courses | 70+ Hours | Verifiable Certificate of Completion | Lifetime Access
4.5 (4,045 ratings)

Course Price

View Course

Current Ratio = Current Assets / Current Liabilities
Quick Ratio (Acid test ratio) = (Current Assets – Inventories) / Current Liabilities
Cash Ratio = Cash and Cash Equivalents / Current Liabilities

3. Activity or Efficiency Ratios

These define how efficiently the company is using its assets and other revenue-generating resources.

Asset Turnover Ratio = Net Sales / Total Assets
Receivables Turnover Ratio =Net Credit Sales / Net Receivables

The denominator can be an end of the year figure or an average figure

Average Collection Period = Accounts Receivable / Credit Sales x 365

365 days can be adjusted to 360 or any other number as per requirement and convention

Degree of Operating Leverage = % of Net Operating Income / % Change in Sales
Days of Sales Outstanding Ratio = Accounts Receivable / Total Annual Sales x 365
Average Payment Period = Accounts Payable / Credit Purchases x 365

Conversion Period

Inventory Conversion Period = (Inventory / COGS) x 365
Receivables Conversion Period = (Receivable / Net Sales) x 365
Payments Conversion Period = (Payables / Purchases) x 365
Cash Conversion Ratio = a +b – c

4. Solvency Ratios

These measures how much debt can be recovered from the resources available to the company. If a company has lesser resources then it can be declared insolvent

Debt Ratio = Total Liability / Total Assets
Debt to Equity Ratio = Total Debt / Total equity
Times Interest Earned Ratio = EBIT / Interest Expense
Debt Service Coverage Ratio = Net Operating Income / Total Debt Service Ratio

5. Market Ratios

EPS = Net Income / Total Number of Shares
Payout Ratio = Dividends / Net Income
Retention Ratio = 1 – Payout Ratio
P/E Ratio = Price / Net Income
Dividend Yield = Dividends / Price

Importance of Financial Ratios

Importance of these ratios can be categorized into two categories, importance for internal users such as the management or the board of directors and importance for external users such as the shareholders who are not aware of the day to day operations and prospective investors.

Ratios such as the activity ratios are more important to the internal users while the ratios such as the market ratios are more important to the investors and staggered shareholders. Other ratios such as solvency and profitability are equally important to both the internal and external users.

Ratios mostly help in comparative analysis in the peer group or time series analysis or even in the trend analysis so that the company can improve where it is lacking and investors can decide whether it is worth investing in a given company or not.

Advantages and Disadvantages of Financial Ratios

Below are the advantages and disadvantages

Advantages of Financial Ratios

Points out Areas of Improvement: Suppose a company has a lower asset turnover ratio, as compared to its competitors it is aware that either it needs to reduce assets or increase sales, this can be done by increasing expense on business development activities or by utilizing idle capacity so the company can formulate the strategies going forward
Planning: Suppose a company’s debt ratio is increasing over time, it gets a hint that it needs to reduce the debt or take up other routes of funding because the assets are not sufficient to pay off the debtor won’t be in times to come. Therefore ratios act as a check on excessive spending or debt accumulation
Defines Limits: Every organization or an industry defines the ideal level of certain ratios. This helps the companies in verifying whether the company ratios fall within the defined limits and therefore keeps a close check on the unwanted or risky endeavors.
Popular: Ratios are a popular tool of analysis and are calculated on a regular basis internally and externally by mostly all companies

Disadvantages of Financial Ratios

Calculation Differences: Every publisher calculates the ratios in a different manner and breaks down the information given in the financial statements and notes to the financial statements. At times they include certain numbers and exclude others. Therefore there is lower uniformity in the numbers published by different publishers. This makes comparison very difficult
Subjected to Accounting Practices: Certain ratios which are not measured using cash flows can be manipulated by accounting practices, for example, using a written down value method for depreciation will inflate the value of the asset and thus show a better solvency position of the company as compared to the true and fair position

Conclusion

Finally, we can say that the ratios help internal and external users of the financial statements to draw conclusions regarding the financial position of the company but at times it may not be easy to calculate them due to variations in their definition and calculation methodology.

However, these facilitate comparison of the company’s performance to its own and to its competitors and therefore it is a good measure of common sizing all kinds of companies within a sector and analyze what strategic or investment decisions should be made.