Financial ratios are essential tools used to evaluate a company’s performance and financial health. They are categorized into various types based on their purpose:
- Liquidity Ratios
These ratios measure a company’s ability to meet short-term obligations.
Current Ratio: Current Assets ÷ Current Liabilities (e.g., 2:1 means good liquidity).
Quick Ratio: (Current Assets - Inventory) ÷ Current Liabilities (more stringent than the current ratio).
Cash Ratio: Cash and Cash Equivalents ÷ Current Liabilities (focuses only on liquid assets).
- Profitability Ratios
They assess how effectively a company generates profit.
Net Profit Margin: Net Profit ÷ Revenue (e.g., 10% means $0.10 profit per $1 revenue).
Return on Assets (ROA): Net Income ÷ Average Total Assets (efficiency in asset usage).
Return on Equity (ROE): Net Income ÷ Average Shareholders’ Equity (returns to shareholders).
- Solvency Ratios
These evaluate a company’s long-term financial stability.
Debt-to-Equity Ratio: Total Debt ÷ Shareholders’ Equity (lower is less risky).
Interest Coverage Ratio: EBIT ÷ Interest Expense (ability to pay interest on debts).
- Efficiency Ratios
These measure how well a company uses its resources.
Inventory Turnover: Cost of Goods Sold ÷ Average Inventory (speed of inventory sales).
Receivables Turnover: Revenue ÷ Average Accounts Receivable (collection efficiency).
Asset Turnover: Revenue ÷ Average Total Assets (asset utilization efficiency).
- Valuation Ratios
These ratios show how the market values a company.
Price-to-Earnings (P/E) Ratio: Market Price per Share ÷ Earnings per Share (future growth expectations).
Price-to-Book (P/B) Ratio: Market Price per Share ÷ Book Value per Share (value relative to book value).
Dividend Yield: Dividends per Share ÷ Market Price per Share (annual dividend return).
- Return Ratios
They analyze the returns generated by the company.
ROCE: EBIT ÷ Capital Employed (efficiency of capital use).
Earnings Growth Rate: Change in EPS over a period.
Sales Growth Rate: Change in sales over a period.
- Coverage Ratios
These indicate a company’s ability to cover its obligations.
Fixed Charge Coverage: (EBIT + Lease Payments) ÷ (Interest + Lease Payments).
Debt Service Coverage: Net Operating Income ÷ Debt Service.
- Growth Ratios
They highlight the company's growth over time.
Dividend Growth Rate: Change in dividends over a period.
Retention Ratio: (Net Income - Dividends) ÷ Net Income (portion of earnings retained).
- Market Ratios
They measure a company's market performance.
Market Capitalization: Shares Outstanding × Market Price per Share.
Earnings per Share (EPS): Net Income ÷ Weighted Average Shares Outstanding.
Dividends per Share: Total Dividends ÷ Shares Outstanding.
- Payout Ratios
They determine how profits are distributed.
Dividend Payout Ratio: Dividends ÷ Earnings (portion paid to shareholders).
Retention Ratio: (Net Income - Dividends) ÷ Net Income (earnings reinvested).
- Turnover Ratios
They assess the efficiency of resource utilization.
Fixed Asset Turnover: Revenue ÷ Average Fixed Assets.
Working Capital Turnover: Revenue ÷ Average Working Capital.
Summary: Financial ratios help analyze liquidity, profitability, efficiency, and market valuation to assess a company’s financial health and performance.
Financial ratios are calculated to analyze a company's financial health, performance, and efficiency. They provide insights that help in decision-making for management, investors, creditors, and other stakeholders.
Here’s an explanation of how and why we calculate financial ratios:
- How to Calculate Financial Ratios
Ratios are calculated using financial data from the company’s financial statements, such as the income statement, balance sheet, and cash flow statement. Each ratio has a specific formula:
Steps:
Gather Data: Extract relevant figures from financial statements (e.g., revenue, expenses, assets, liabilities, etc.).
Apply the Formula: Use the formula for the specific ratio. For example:
Current Ratio = Current Assets ÷ Current Liabilities.
Net Profit Margin = Net Profit ÷ Revenue.
- Interpret Results: Compare the calculated ratio against industry benchmarks, historical performance, or competitors.
- Why We Calculate Financial Ratios
a. To Assess Financial Health
Liquidity Ratios: Assess whether a company can meet short-term obligations. Example: A low current ratio might indicate cash flow problems.
Solvency Ratios: Determine long-term financial stability. Example: A high debt-to-equity ratio signals reliance on debt.
b. To Evaluate Profitability
Profitability Ratios: Show how efficiently a company generates profit. Example: A declining net profit margin may indicate rising costs or pricing issues.
c. To Measure Operational Efficiency
Efficiency Ratios: Evaluate resource utilization, such as inventory or receivables management. Example: High inventory turnover indicates efficient stock management.
d. To Guide Investment Decisions
Valuation Ratios: Help investors determine whether a stock is overvalued or undervalued. Example: A high P/E ratio may suggest growth expectations, but also potential overvaluation.
e. To Track Growth
Growth Ratios: Show trends in revenue, earnings, or dividends. Example: A steady increase in sales growth suggests market demand and effective strategies.
f. To Ensure Payout Efficiency
Payout Ratios: Determine how profits are distributed or retained for reinvestment. Example: A high dividend payout ratio might limit reinvestment opportunities.
g. To Compare with Peers
Ratios provide a standard way to compare companies within the same industry. Example: Comparing ROE of two companies shows which generates better shareholder returns.
h. To Identify Risks
Ratios highlight potential risks, such as over-leverage, liquidity issues, or operational inefficiencies.
Examples of Application
Management: Uses ratios to improve efficiency and plan for future growth.
Investors: Analyze ratios to decide whether to buy, hold, or sell shares.
Creditors: Evaluate a company’s ability to repay debts before lending.
Regulators: Assess compliance with financial regulations.
Conclusion
Financial ratios simplify complex financial data into understandable metrics. They are indispensable for analyzing performance, making informed decisions, and ensuring the business operates efficiently and sustainably.
