What are financial ratios?

Financial ratios are basic calculations using quantitative data from a company’s financial
statements. They are used to get insights and important information on the company’s
performance, profitability, and financial health.
Common financial ratios come from a company’s balance sheet, income statement, and cash
flow statement.
Businesses use financial ratios to determine liquidity, debt concentration, growth,
profitability, and market value.

Why are financial ratios so important?

Financial ratios are sometimes referred to as accounting ratios or finance ratios. These ratios
are important for assessing how a company generates revenue and profits using business
expenses and assets in each period. Internal and external stakeholders use financial ratios for
competitor analysis, market valuation, benchmarking, and performance management.
Often, financial ratios are considered the best indicator of a company’s financial health,
which explains why it’s so important to understand these ratios and what their results mean.

Financial planning and analysis professionals calculate financial ratios for the following
reasons for internal reasons, including:

1. ● Measuring return on capital investments

2. ● Calculating profit margins
3. ● To assess a company’s efficiency and how costs are allocated
4. ● Assessing a company’s efficiency and how costs are allocated
5. ● Determining how much debt is used to finance operations
 6. ● Identifying trends in profitability
7. ● Managing working capital and short-term funding requirements
8. ● Identifying operating bottlenecks and assessing inventory management systems
9. ● Measuring a company’s ability to settle debt and liabilities

External stakeholders use financial ratios to:

1. ● Carry out competitor analysis
2. ● Determine whether to finance a company in the form of debt
3. ● Assess how profitable a company is
4. ● Determine whether to provide equity financing or buy shares in the company
5. ● Calculate tax liabilities
6. ● Measure a company’s market value
7. ● Calculate return on shareholders’ equity
8. ● Perform market analysis

The common financial ratios every business should track are

1) liquidity ratios
2) leverage ratios
3) efficiency ratio
4) profitability ratios
5) market value ratios

1) Liquidity ratios
Companies use liquidity ratios to measure working capital performance – the money
available to meet your current, short-term obligations. Simply put, companies need
liquidity to pay their bills. Liquidity ratios measure a company’s capacity to meet its
short-term obligations and are a vital indicator of its financial health.
Liquidity is different from solvency, which measures a company’s ability to pay all its
debts.
There are different forms of liquidity ratio.
 Current ratio:
Current Assets / Current Liabilities
The current ratio measures how a business’s current assets, such as cash, cash
equivalents, accounts receivable, and inventories, are used to settle current liabilities
such as accounts payable.
Significance:
It provides a measure of degree to which current assets cover current liabilities.
The excess of current assets over current liabilities provides a measure of safety
margin available against uncertainty in realisation of current assets and flow of
funds. The ratio should be reasonable. It should neither be very high or very low.
Both the situations have their inherent disadvantages. A very high current ratio
implies heavy investment in current assets which is not a good sign as it reflects
underutilisation or improper utilisation of resources. A low ratio endangers the
business and puts it at risk of facing a situation where it will not be able to pay its
short-term debt on time. If this problem persists, it may affect firm’s credit
worthiness adversely.
Normally, it is safe to have this ratio within the range of 2:1.
 Quick ratio (Acid-test ratio):
(Current Assets – Inventories – Prepaid Expenses) / Current Liabilities
This ratio excludes inventories from current assets but includes:
Cash, Cash equivalents, Accounts receivable
A quick ratio of one is considered the industry average. This number suggests that a
company may not be able to meet its current obligations because it has insufficient
assets to liquidate.
Significance:
The ratio provides a measure of the capacity of the business to meet its short-term
obligations without any flaw. Normally, it is advocated to be safe to have a ratio of
1:1 as unnecessarily low ratio will be very risky and a high ratio suggests
unnecessarily deployment of resources in otherwise less profitable short-term
investments.

2) Leverage ratios (Solvency Ratio)

Companies often use short and long-term debt to finance business operations. Leverage
ratios measure a company’s debt.
The persons who have advanced money to the business on long-term basis are
interested in safety of their periodic payment of interest as well as the repayment of
principal amount at the end of the loan period. Solvency ratios are calculated to
determine the ability of the business to service its debt in the long run.
The types of leverage ratios to consider are:
 Debt ratio:
Total Debt / Total Assets
The debt ratio measures the proportion of debt a company has to its total assets. A high
debt ratio indicates that a company is highly leveraged.
 Debt to equity ratio:
Total Debt / Total Equity
The debt-to-equity ratio measures a company’s debt liability compared to shareholders’
equity. This ratio is important for investors because debt obligations often have a higher
priority if a company goes bankrupt.
Significance:
This ratio measures the degree of indebtedness of an enterprise and gives an idea
to the long-term lender regarding extent of security of the debt. As indicated
earlier, a low debt equity ratio reflects more security. A high ratio, on the other
hand, is considered risky as it may put the firm into difficulty in meeting its
obligations to outsiders. However, from the perspective of the owners, greater use
of debt (trading on equity) may help in ensuring higher returns for them if the
rate of earnings on capital employed is higher than the rate of interest payable.

3) Efficiency ratios
Efficiency ratios show how effectively a company uses working capital to generate
sales.
A fall in the efficiency ratio indicates improved profitability.
 Asset turnover ratio:
Net sales / Average total assets
Companies use assets to generate sales. The asset turnover ratio measures how much
net sales are made from average assets.
 Inventory turnover:
Cost of goods sold / Average value of inventory
For companies in the manufacturing and production industries with high inventory
levels, inventory turnover is an important ratio that measures how often inventory is
used and replaced for operations.
Significance:
It studies the frequency of conversion of inventory of finished goods into revenue
from operations. It is also a measure of liquidity. It determines how many times
inventory is purchased or replaced during a year. Low turnover of inventory may
be due to bad buying, obsolete inventory, etc., and is a danger signal. High
turnover is good but it must be carefully interpreted as it may be due to buying in
small lots or selling quickly at low margin to realise cash. Thus, it throws light on
utilisation of inventory of goods.

4) Profitability ratios
A business’s profit is calculated as net sales less expenses. Profitability ratios measure
how a company generates profits using available resources over a given period.
Higher ratio results are often more favourable, but these ratios provide much more
information when compared to results of similar companies, the company’s own
historical performance, or the industry average.
 Return on assets (ROA):
Net income / Total assets
Companies use the return on assets ratio to determine how much profits they generate
from total assets or resources, including current and noncurrent assets.
 Return on equity (ROE):
Net income / Total equity
Shareholders’ equity is capital investments. The return on equity measures how much
profit a business generates from shareholders’ equity.

5) Market Value ratios

Market value ratios are used to measure how valuable a company is.
These ratios are usually used by external stakeholders such as investors or market
analysts. However, internal management can also use them to monitor value per
company share.
 Earnings per share ratio (EPS):
(Net Income – Preferred Dividends) / End-of-Period Common Shares Outstanding
The earnings per share ratio, also known as EPS, shows how much profit is attributable
to each company share.
 Price earnings ratio (P/E):
Share price / Earnings per share
The PE ratio is a key investor ratio that measures how valuable a company is relative to
its book value earnings per share.
Example 1
Example 2
Example 3
Example 4
Example 5