Uses and Users of Financial Ratio Analysis

Analysis of financial ratios serves two main purposes:

1. Track company performance

Determining individual financial ratios per period and tracking the change in their values
over time is done to spot trends that may be developing in a company. For example, an
increasing debt-to-asset ratio may indicate that a company is overburdened with debt and
may eventually be facing default risk.

2. Make comparative judgments regarding company performance

Comparing financial ratios with that of major competitors is done to identify whether a
company is performing better or worse than the industry average. For example, comparing
the return on assets between companies helps an analyst or investor to determine which
company is making the most efficient use of its assets.

Users of financial ratios include parties external and internal to the company:

 External users: Financial analysts, retail investors, creditors, competitors, tax

Liquidity Ratios

Liquidity ratios are financial ratios that measure a company’s ability to repay both short- and
long-term obligations. Common liquidity ratios include the following:

The current ratio measures a company’s ability to pay off short-term liabilities with current
assets:

Current ratio = Current assets / Current liabilities

The acid-test ratio measures a company’s ability to pay off short-term liabilities with quick
assets:

Acid-test ratio = Current assets – Inventories / Current liabilities

The cash ratio measures a company’s ability to pay off short-term liabilities with cash and
cash equivalents:

Cash ratio = Cash and Cash equivalents / Current Liabilities

The operating cash flow ratio is a measure of the number of times a company can pay off
current liabilities with the cash generated in a given period:

Operating cash flow ratio = Operating cash flow / Current liabilities

Leverage Financial Ratios

Leverage ratios measure the amount of capital that comes from debt. In other words, leverage
financial ratios are used to evaluate a company’s debt levels. Common leverage ratios include
the following:

The debt ratio measures the relative amount of a company’s assets that are provided from
debt:

Debt ratio = Total liabilities / Total assets

The debt to equity ratio calculates the weight of total debt and financial liabilities against
shareholders’ equity:

Debt to equity ratio = Total liabilities / Shareholder’s equity

The interest coverage ratio shows how easily a company can pay its interest expenses:

Interest coverage ratio = Operating income / Interest expenses

The debt service coverage ratio reveals how easily a company can pay its debt obligations:

Debt service coverage ratio = Operating income / Total debt service

Efficiency Ratios
Efficiency ratios, also known as activity financial ratios, are used to measure how well a
company is utilizing its assets and resources. Common efficiency ratios include:

The asset turnover ratio measures a company’s ability to generate sales from assets:

Asset turnover ratio = Net sales / Average total assets

The inventory turnover ratio measures how many times a company’s inventory is sold and
replaced over a given period:

Inventory turnover ratio = Cost of goods sold / Average inventory

The accounts receivable turnover ratio measures how many times a company can turn
receivables into cash over a given period:

Receivables turnover ratio = Net credit sales / Average accounts receivable

Profitability Ratios

Profitability ratios measure a company’s ability to generate income relative to revenue,

The gross margin ratio compares the gross profit of a company to its net sales to show how
much profit a company makes after paying its cost of goods sold:

Gross margin ratio = Gross profit / Net sales

The operating margin ratio compares the operating income of a company to its net sales to
determine operating efficiency:

Operating margin ratio = Operating income / Net sales

The return on assets ratio measures how efficiently a company is using its assets to generate
profit:

Return on assets ratio = Net income / Total assets

 
The return on equity ratio measures how efficiently a company is using its equity to generate
profit:

Return on equity ratio = Net income / Shareholder’s equity

Market Value Ratios

Market value ratios are used to evaluate the share price of a company’s stock. Common
market value ratios include the following:

The book value per share ratio calculates the per-share value of a company based on the
equity available to shareholders:

Book value per share ratio = (Shareholder’s equity – Preferred equity) / Total common
shares outstanding

The dividend yield ratio measures the amount of dividends attributed to shareholders relative
to the market value per share:

Dividend yield ratio = Dividend per share / Share price

The earnings per share ratio measures the amount of net income earned for each share
outstanding:

Earnings per share ratio = Net earnings / Total shares outstanding

The price-earnings ratio compares a company’s share price to its earnings per share:

Price-earnings ratio = Share price / Earnings per share