Clearly, ratios indicates how many times one number contained other and Financial ratio 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.
WHAT ARE FINANCIAL RATIOS? WHO USE THEM?
Using the values in financial statements to obtain meaningful information about the company, we 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 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 understanding and applying certain ratios correctly can help you become a smarter investor.
In most cases, financial ratios are uses by 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 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 uses its assets most effectively.
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FINANCIAL RATIOS ARE GROUPED INTO 5 CATEGORIES
There are 5 main categories of Financial Ratios:
1. Liquidity Ratios
The liquidity ratio is a measure of the company's ability to fulfill its short-term debt obligations. These ratios 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 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 measures 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 an improvement to the quick ratio. It 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 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 the ratio of debt owned by a bank to its equity/capital.
Debt ratio = Total liabilities / Total assets
It measure the total amount of companies assets provided by obtaining debt.
Debt-to-equity swap = Total debt / Shareholders' equity
It calculates the amount of financial liabilities and debt against a shareholder's equity.
Interest coverage ratio = Operating income / Interest expenses
It 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 calculates sales as a percentage of company assets.
Inventory turnover ratio = Cost of goods sold / Average inventory
It measures how many times has the company's inventory been sold and replaced.
Receivable turnover ratio= Net credit sales / Average accounts receivable
It 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
Profitability ratio is 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 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 compares a company’s operating income with its net sales to determine operating efficiency.
Return on assets sale= Net income / Total assets
It measures how efficiently a company uses its assets to generate profits.
Return on equity ratio= Net income / Shareholder’s equity
It measure the efficiency of a company's use of its equity to generate profits.
5. Market Value Ratios
The market value ratio evaluate 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 under priced.
Book value per share= Shareholder’s equity / Total share outstanding
This is 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 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 RATIOS ANALYSIS AND INTERPRETATION
When you 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 easy to participate in calculating various financial ratios, so that you forget the original purpose. When reviewing all aspects of financial performance, it is 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.
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