Easy Guide to Financial Ratios | Definition, Ratios and Example

Business owners, analysts, investors and other stakeholders review, contrast, and evaluate this financial data in order to make crucial financial decisions. There are various techniques and methodologies used for financial statement analysis and are used to interpret the crucial financial information. Financial ratio analysis is one such widely utilized tool. In this article we will discus various financial ratio, its formula, and its significance to the business.

What are Financial Ratios?

An important tool for analyzing financial statements is financing ratios. To analyse a company's financial accounts, two or more financial data are compared. These ratios show a relationship between one or more financial figures available from financial statements. Shareholders, creditors, and other stakeholders can utilise it to learn about a company's profitability and financial stability. Financial ratios, which are also known as accounting ratios, are used to monitor company performance and make important business decisions.

All of these ratios are employed to track business performance and assess results in relation to those of competitors. A fraction, percentage, proportion, or number of times can also be used to express these ratios. It is necessary to enable the use of the two or more financial ratios that can be extracted from financial statements and used to build financial ratios. As a result, if the financial statements containing correct data, the ratios will also offer an accurate assessment of the company's financial results.

Various Types of Financial Ratios

1. Liquidity Ratios
2. Profitability Ratios
3. Solvency Ratios
4. Activity or Efficiency Ratio

1. Liquidity Ratios

When determining if a corporation has enough cash on hand to pay off its short-term debts, then company should monitor using the liquidity ratio.  Liquidity Ratio suggests that the company will be able to settle its debts. A liquid ratio of at least 2x is acceptable.

Various Types of Liquidity Ratios:

• Current Ratio: A company's ability to repay its debts in the upcoming year can be estimated using the current ratio. Cash, inventory, accounts receivable (or debtors) and other current assets are examples of current assets. Accounts payable to creditors, taxes owing, and any other current liabilities are all examples of current liabilities. The most popular liquidity ratio for assessing a company's current assets to current liabilities is current ratio. Ideal Current Ratio of the company is 2:1

Current Ratio = Current Assets / Current Liabilities

• Quick Ratio: A more conservative method of assessing a company's short-term solvency is to use the quick ratio. It consists of the company's most liquid assets, known as fast / liquid assets. Assets that are difficult to liquidate rapidly, such inventories and pre-paid expenses, are not considered quick assets. Quick Ratio is also known as Acid Test Ratio.

Quick Ratio = (Current Assets - Inventories)/ Current Liabilities

• Cash Ratio: A company's total cash and cash equivalents are compared to its current obligations to determine its cash ratio. This indicator shows how well a business can use its most liquid assets to pay its short-term debt. Company is considered to be financially solid if it has a Cash Ratio of 1 or higher.

Cash Ratio = (Cash +Marketable securities ) / Current Liabilities

2. Profitability Ratio

Profitability ratios are used to assess a company's capacity to generate profits over time in relation to its revenue, operating expenses, assets, or shareholders' equity. Financial data at a specific point in time is used to perform the evaluation. Efficiency ratios evaluate how effectively a company uses its resources internally to produce profits. One can contrast these efficiency ratios with profitability ratios (as opposed to after-cost profits).

Results with a higher ratio are frequently more favorable. However, this ratio's results must be compared with :

1. The results of similar companies
2. The company’s own previous performance
3. Industry average

• Gross Profit Margin: The percentage of production expenses to sales income is expressed by the gross profit ratio. Money earned from Sales is referred to as revenue. Cost of goods sold refers to the expenses a business has to make in order to manufacture the products it sells. COGS consists of labour costs, raw material costs, processing costs, and other production costs and higher gross profit margin indicates more effective business practices. Gross Profit margin demonstrates how much money a business makes following the deduction of all costs associated with providing goods and services.

Gross Profit Margin % = Gross Profit / Revenue

Gross Profit= Revenue − Cost of Goods Sold

• Operating Margin: EBIT(earnings before interest and taxes) is another name for operating income. Revenue less Cost of Goods Sold (COGS) and Selling, general, and administrative costs of running a business, excluding interest and taxes, is known as EBIT, or operational earnings. After accounting for variable expenses, a company's operating margin measures the profit it makes on each rupee of sales. Before paying interest or taxes, these variable costs include labour, raw materials, and production costs. Higher Operating Margin ratios show that a company runs efficiently and does a good job of translating sales into profits.

Operating Margin % = (Gross Profits- Operating Expense) / Revenue

• Profit Margin: The profit margin ratio can be used by any firm to calculate the amount of profit it generates from all of its  revenue. It is simple to evaluate and contrast the overall profitability of a business with that of its rivals.

Profit Margin % = (Revenue –Operating expense + non-operating income-Interest Expense- Income taxes)/Revenue

• Earnings per Share (EPS): To determine earnings per share, divide a company's net profit by the total number of outstanding common shares (EPS) Commonly, the weighted average number of shares outstanding is used to compute. Because the corporation issues shares throughout the year, this occurs. Additionally, Diluted EPS includes outstanding warrants, convertible securities, and options all of which have an impact on the number of outstanding shares.

Earning Per Share (EPS) = (Net Income– Preferred Dividend) / Weighted Average Outstanding Shares)

Solvency Ratios

Solvency Ratio is used by potential business lenders / investor to determine a company's ability to pay off long-term debt. Company's solvency ratio help to assesses its financial health by determining if its cash flow is sufficient to pay for its long-term loans and liabilities. An unfavorable ratio may indicate that a company faces a chance of missing its debt payments. When assessing a company's credit worthiness, potential lenders and bond investors typically use solvency ratios. Both solvency and liquidity ratios are used to evaluate the financial health of a corporation, although solvency ratios have a longer-term outlook.

• Debt Equity Ratio or D/E ratio: Both long-term and short-term debt obligations are considered debt. Capital owned by the shareholder, or the value of all shares in issue plus reserves, is included in equity. The D/E ratio demonstrates how debt is utilized to finance a business, just like the debt-to-assets ratio does. The danger of default increases when the ratio rises since a company has more debt on its books. In the event of a liquidation, the debt-to-equity ratio looks at how much of the debt can be paid off by equity.

Debt to Equity Ratio or D/E = Total Debt / Total Equity

• Debt Ratio: A debt ratio measures the amount of debt a company has in relation to its total assets. Industry-specific debt ratios vary widely, with capital-intensive businesses typically having far higher debt ratios than others. A debt-to-assets ratio greater than 1x, or 100 percent, indicates that a corporation has more debt than assets.

Debt Ratio = Total Liabilities / Total Asset

• Interest Coverage Ratio: How many times a company's available earnings can cover its current interest payments is determined by the interest coverage ratio. To put it another way, it determines a company's margin of safety for making interest payments on its debt over a certain time frame. More is better when it comes to the ratio. If the ratio is less than 1.5, it may indicate that a company will struggle to pay the interest on its debt.

Interest Coverage Ratio = Earnings before interest and taxes (EBIT) / Interest Expense

Activity or Efficiency Ratio 

The efficiency with which a business uses its resources to produce revenue and cash or bank balance is measured by the activity ratio. To put it another way, it determines a company's margin of safety for making interest payments on its debt over a certain time frame. Activity ratios can be used by analysts to evaluate an organization's inventory control, which is essential to its operational flexibility and overall financial health. Investors and research analysts use activity ratios as a financial metric to assess how well a company uses its resources to generate revenue and cash.

Activity ratios can be used to assess the financial standing of a single business overtime or to compare two businesses operating in the same sector.

• Accounts Receivable Ratio: The ratio of accounts receivable turnover determines a company's capacity to collect money from customers. Total credit sales for a time period are divided by the typical accounts receivable balance. A low ratio suggests that the collection process is flawed.

Account Receivable Ratio = Annual Sales / Accounts Receivable

• Inventory Turnover Ratio: How frequently the inventory balance is sold over the course of a fiscal year is determined by the inventory turnover ratio. The cost of things sold is divided by the average inventory for the specified time period. Higher estimate suggest that moving a company's inventory will be rather simple.

Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory

• Asset Turnover Ratio: The assets turnover ratio measures how efficiently a business uses its assets to close a deal. To calculate how efficiently a corporation uses its resources, divide total revenues by total assets. Smaller ratios may indicate that a company is having trouble moving its products.

Asset Turnover Ratio = Net Revenue / Assets

Objectives of Financial Ratio Analysis

Financial statements and other financial data must be able to be understood by all business stakeholders. Ratio analysis hence becomes a crucial technique for managing and analyzing finances. The aims of a financial ratio study of an organization are as follows:

1. Measure the Profitability and Growth

The ultimate aim of every business is to make money. How would you determine whether the profit made by XYZ Company last year was good or bad if I told you that it was 5 lakhs? Ratio analysis provides the context needed to calculate profitability. A company's profitability can be determined by looking at ratios like its gross profit, net profit, and expense ratios, among others. Management can use these ratios to pinpoint and resolve issue areas.

2. Evaluate Operational Efficiency of an company

A company's efficiency in managing its assets and other resources can be shown in certain ratios. It is essential that assets and financial resources be allocated and utilized sensibly in order to prevent unnecessary spending. Any asset mismanagement will be shown through turnover and efficiency ratios.

3. To understand the Liquidity position of the company

Every business must make sure that some of its assets are liquid in case it requires cash immediately. As a result, ratios like the quick ratio and the current ratio are used to evaluate the liquidity of a corporation. These support a business' ability to maintain the required level of short-term solvency.

4. To gauge an understating of Financial Strength

It is possible to use some ratios to assess a company's long-term viability. They are able to determine whether a company is overly leveraged or whether its assets are under pressure. Management will have to take fast action to remedy the situation in order to prevent liquidation in the future. Leverage ratios, debt-equity ratios, and other comparable ratios are a few examples.

5. Comparison with Industry Standards and Competitors

The ratios must be compared to industry norms in order to have a clearer view of the organization's fiscal health and status. The management can implement corrective measures if the company doesn't satisfy market standards. To determine how far the company has come, the ratios can also be compared to ratios from prior years. The phrase for this is trend analysis.

Various advantages of Financial Ratio Analysis

The firm's financial, investment, and operational decisions will be supported or refuted by ratio analysis. The management is able to assess and evaluate the firm's financial situation as well as the results of their decisions thanks to their conversion of the financial statement into comparative statistics.

• Simple ratios of operating efficiency, financial efficiency, solvency, long-term positions, and other metrics are used to simplify complex accounting statements and financial data.
• Ratio analysis helps in locating problem areas and bringing them to management's attention. Ratios will help in recognizing these problems because some information in the complex financial statements is lost.
• Allows for comparisons between the company and other businesses, with industry standards, and inside the company itself, among other things. This will help the company to comprehend its financial position within the economy.

Various limitations of Financial Ratio Analysis

• The analysis's data is based on the company's own previously published results. Ratio analysis indicators are therefore not necessarily a reliable predictor of future company success.
• There are gaps in time between financial statements because they are often released. If there has been inflation between periods, real prices are not depicted in the financial accounts. As a result, the numbers are not comparable throughout time periods until they are adjusted for inflation.
• Financial reporting may be significantly impacted if the company's accounting standards and procedures have changed. In this case, the primary financial indicators utilized in ratio analysis are altered, and the financial results reported following the alteration are not comparable to those recorded prior to the alteration. The analyst is accountable for remaining current with adjustments to accounting principles. The adjustments are often noted in the part after the financial statements.
• Major changes could occur in a company's operating framework, supply chain strategy, and even the products it offers. Comparing financial metrics before and after a company makes significant operational changes could result in erroneous conclusions about the success and future prospects of the company.
• Analysts should take into account seasonal variables because they can result in limitations on ratio analysis. The analysis's findings could be interpreted incorrectly because it was not possible to adjust the ratio analysis for seasonality effects.
• Ratio analysis is based on the data that the company provides in its financial records. The management of the company could alter this statistics to reflect a better performance than it actually has. As a result, because information falsification cannot be identified by basic analysis, ratio analysis may not accurately reflect the firm's fundamental characteristics. Before making any findings, an analyst must be fully aware of these potential manipulations and do exhaustive due diligence.

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