Clearly, ratios indicate how many times a number contained other and a Financial Ratio is a key to knowing your investments. It is the relative magnitude of two selected numerical values taken from the financial statements of a company.
Here, we are not talking about mathematics, but about practical tools that will help you to understand the broader prospects. In addition, it will help you understand the information that comes with your investment and make smart choices.
Therefore, this will improve your performance and results.
In This Article
- What are Financial Ratios? Who uses them?
- Uses of Financial Ratios
- Financial Ratios are grouped into 5 Categories
- Liquidity Ratios
- Leverage Ratios
- Efficiency Ratios
- Profitability Ratios
- Market Value Ratios
What are Financial Ratios? Who uses them?
Using the values in financial statements to obtain meaningful information about the company, we thus create Financial ratios.
Generally, investors and analysts use ratio analysis to assess the financial health of a company, by examining past and current financial statements.
We subsequently use the numbers found in the company's financial statements (balance sheet, income statement, and cash flow statement) for quantitative analysis and to evaluate the company's liquidity, leverage, growth, profitability, profitability, rate of return, valuation, etc.
By thus understanding and applying certain ratios correctly can help you become a smarter investor.
Also, in most cases financial ratios are used mainly by the external users (which includes financial analysts, retail investors, creditors, competitors, tax authorities, regulatory authorities, and industry observers) and internal users (management team, employees, and owners).
Uses of Financial Ratios
Financial ratio analysis has two main purposes:
1. Track company performance
Firstly, the purpose of determining individual financial ratios for each period and tracking changes in their values over time is to discover possible trends in the company.
For example, the ever-increasing debt-to-asset ratio may indicate that the company is heavily indebted and may eventually face the risk of default.
2. Compare and judge the company performance
Secondly, compare financial ratios with those of major competitors to consequently determine whether the company’s performance is better or worse than the industry average.
For example, comparing the return on assets between companies can help analysts or investors determine which company thus uses its assets most effectively.
Financial Ratios are grouped into 5 Categories
There are 5 main categories of Financial Ratios:
1. Liquidity Ratios
The liquidity ratio is thus a measure of the company's ability to fulfill its short-term debt obligations. These ratios consequently measure a company's ability to repay its short-term debt when it matures.
Current ratio = Current assets / Current liabilities
Current ratio- The current ratio thus measures the company's ability to repay short-term liabilities with current assets:
Acid-test ratio = Current assets-Inventories / Current Liabilities
Acid-Test Ratio- The acid-test ratio also known as a quick ratio. It thus measures the current liquidity and position of the company.
Cash ratio= Cash and Cash equivalent / Current Liabilities
Cash Ratio- The cash ratio is the ratio of a company's cash and cash equivalent assets to its total liabilities. The cash ratio is thus an improvement to the quick ratio. It also indicates the degree to which the funds available at any time can repay current liabilities.
Operating cash flow ratio = Operating cash flow / Current Liabilities
Operating cash flow Ratio- It consequently measures the number of times the company can use the cash generated in a given period to repay current liabilities.
2. Leverage Ratios
Leverage ratio is thus the ratio of debt owed by a bank to its equity/capital.
Debt ratio = Total liabilities / Total assets
It consequently measures the total amount of companies' assets provided by obtaining debt.
Debt-to-equity swap = Total debt / Shareholders' equity
It thus calculates the number of financial liabilities and the debt against a shareholder's equity.
Interest coverage ratio = Operating income / Interest expenses
It thus shows that a company can pay its interest with how much ease.
Debt service coverage ratio = Operating income / Total debt service
It shows how easily a company can pay its debt.
3. Efficiency Ratios
The efficiency ratio measures a company's ability to effectively use its assets and manage its liabilities in the current period or in the short term.
Assets turnover ratio = Net sale / Total Assets
Asset turnover rate consequently calculates sales as a percentage of company assets.
Inventory turnover ratio = Cost of goods sold / Average inventory
It consequently measures how many times has the company's inventory been sold and replaced.
Receivable turnover ratio= Net credit sales / Average accounts receivable
It thus measures the number of times a company can convert accounts receivable into cash in a given period.
Days sales in turnover ratio= 365 days / Inventory turnover ratio
Measures the average number of days a company holds inventory before selling it to customers.
4. Profitability Ratios
A profitability ratio is thus a type of financial indicator that is used to evaluate a company's income-generating ability over time relative to its income, operating costs, balance sheet assets, or shareholder equity by using data at a specific point in time.
Gross margin ratio= Gross profit / Net sales
The gross margin subsequently compares the company's gross profit with its net sales to show how much profit the company can make after paying the cost of its goods sold.
Operating margin ratio= Operating income / Net sales
It thus compares a company’s operating income with its net sales to determine operating efficiency.
Return on assets sale= Net income / Total assets
It thus measures how efficiently a company uses its assets to generate profits.
Return on equity ratio= Net income / Shareholder’s equity
It thus measures the efficiency of a company's use of its equity to generate profits.
5. Market Value Ratios
The market value ratio consequently evaluates the current share price of a listed company's stock. Current and potential investors use these ratios to determine whether the company’s stock is overpriced or underpriced.
Book value per share= Shareholder’s equity / Total share outstanding
This is subsequently a benchmark to see whether the value of each stock market is higher or lower, and is used as a basis for deciding whether to buy or sell stocks.
Dividend yield ratio= Dividend per share / Share price
This is thus the investor's return on investment if investors buy stocks at the current market price.
Earnings per share ratio= Net earnings / Total shares outstanding
This does not reflect the market price of the company’s stock in any way, but it used by investors to arrive at the price they think the stock is worth
Price-earnings ratio= Share price / Earnings per share
It compares the company's stock price with its earnings per share.
Financial Ratio Analysis and Interpretation
When you consequently stop thinking about what the numbers tell you, it makes sense to analyze and interpret financial ratios. In terms of debt, companies with less debt and more assets will be financially stronger.
Therefore, a ratio of less than 1 is stronger than a ratio of 5. However, as long as it is under control during the growth period, it may be strategically advantageous to assume debt.
Undoubtedly, when analyzing the financial results of a company or comparing multiple companies, it is thus easy to participate in calculating various financial ratios, so that you forget the original purpose.
When reviewing all aspects of financial performance, it is consequently important to highlight any major changes in performance, whether it is compared to last year or compared to competitors.
Thus, highlighting major changes allows you to focus on key events or major factors that may have a significant impact on the company.
Finally, examine financial performance in the context of the political, business, and economic environment in which the business operates.
Empower yourselves with Investify Wealth Tech Pvt Ltd's exclusive range of investment and personal finance solutions, and secure your future today!
