Financial Ratios
By using numerical data taken from a company’s financial statements, financial ratios are used to glean insightful information about it. Financial statements such as the balance sheet, income statement, and cash flow statement provide numerical values that are used for quantitative analysis to evaluate various aspects of a company’s performance including liquidity, leverage, growth, margins, profitability, rates of return, valuation, and more.
A variety of financial ratios serve as indicators of a company’s performance, financial stability, and operational efficiency. Some of the ratios that are commonly used in financial analysis are stability ratios, asset turnover ratios, operating profitability ratios, business risk ratios, and financial risk ratios. Each of these ratios provides valuable information on various aspects of the overall condition and effectiveness of a company’s financial position.
History of Financial Ratios
Financial ratio analysis has a lengthy history, with key advancements taking place in the eighteenth century. During this period, several improvements were made, including the conception of a large number of ratios, the establishment of proper ratio criteria, and the need for inter-firm analysis, leading to the development of relative ratio criteria. The enactment of the federal income tax code in 1913 and the founding of the Federal Reserve System in 1914 are two key exogenous events that influenced the requirement for ratios. In the 1920s, the interest in ratio analysis expanded substantially, with many publications on the topic.
Critics of ratio analysis also appeared, with concerns raised about the time sensitivity fix of ratios and their potential for manipulation. However, research indicated that ratios could forecast a firm’s failure with a high degree of accuracy, leading to the eventual inclusion of cash flow statement elements in ratio analysis. The financial health of a company can still be determined in large part by looking at ratios, with different ratios revealing different information.
The Objective of Financial Ratio Analysis
Financial ratios examine a company’s financial performance, track it over time, and compare it to industry benchmarks and competitors. There are two main purposes for conducting financial ratio analysis.
Monitoring Firm Performance
Analyzing financial ratios over time helps discover emerging trends in a company’s performance. For example, an upward trend in a company’s debt-to-asset ratio may indicate an over-reliance on debt and potential default risk.
Assessing Differences between Things
Financial ratio comparisons between a firm and its rivals can be used to assess how well the company is doing in comparison to industry benchmarks. For instance, comparing a company’s return on assets against those of its rivals might show whether one is making the best use of its resources. Both internal and external stakeholders can learn more about a company’s financial performance by using financial ratios.
Types of Financial Ratios
Financial ratios can be categorized into several types based on the aspect of a company’s performance they analyze. Here are some of the most common types of financial ratios:
Liquidity Ratio Analysis
The ability of a company to pay its short-term debts is determined by liquidity ratio analysis, which can be computed in several different ways.
Current Ratio
The current ratio, a crucial indicator of a company’s short-term liquidity, compares a company’s current assets to its current liabilities.
Current Assets/Current Liabilities = Current Ratio
For the repayment of simple liabilities, a current ratio of 2:1 is ideal. A ratio of less than 2 might make repayment challenging and have an impact on business operations.
Quick Ratio/Acid Test Ratio
The best current ratio for simple liability repayment is 2:1. A ratio of less than 2 might make repayment challenging and have an impact on business operations.
(Current Assets – Inventory) / Current Liability is the formula for the acid test.
Formula Quick Ratio = Quick Assets / Current Liabilities or Quick Liabilities.
Absolute Liquidity Ratio
Inventory and receivables are not included in the calculation of the absolute liquidity ratio for current assets. This ratio, which should be 1:2, aids in a better understanding of liquidity.
Formula: Absolute Liquidity Ratio =Cash + Marketable Securities + Net Receivables and Debtors
Cash Ratio
A company’s capacity to settle its present obligations entirely out of cash and cash equivalents is gauged by the cash ratio.
Formula: Cash Ratio= (Cash + Marketable Securities) / Current Liabilities
Turnover Ratio Analysis
Analysis of turnover ratios quantifies how well resources are used. It is calculated separately for each asset type and is also referred to as the activity ratio.
Inventory Turnover Ratio
This ratio demonstrates how large the inventory is in cash flow.
Formula: Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory
Receivable Turnover Ratio
This ratio reflects the effectiveness with which a company converts its accounts receivable into cash.
Formula: Turnover= Ratio Average Accounts Receivable / Net Credit Sales
Capital Turnover Ratio
The efficiency of a company’s use of its financial resources is gauged by the capital turnover ratio.
Formula: Capital Turnover Ratio =Net Sales or Cost of Goods Sold / Capital Employed
Asset Turnover Ratio
This ratio reveals the number of times net tangible assets turns over during a year, indicating the efficiency of asset utilization.
Formula: Asset Turnover Ratio= Turnover / Net Tangible Assets
Net Working Capital Turnover Ratio
This ratio shows whether working capital has been utilized effectively in generating sales.
Formula: Asset Turnover Ratio = Net Sales / Net Working Capital
Cash Conversion Cycle
This ratio shows how long it takes a business to turn cash outflows into cash inflows.
Formula: Cash Conversion Cycle = Receivable Days + Inventory Days – Payable Days
Functioning Profitability Ratio analysis
The operating profitability ratio gauges a company’s efficiency and profitability. One of the most crucial metrics in this research is profitability ratios.
Earning Margin
Earning margin is a percentage ratio measuring profitability by comparing net income to turnover. It represents the profit proportion and is determined by dividing net income by turnover, multiplied by 100. Formula: Earning Margin = (Net Income / Turnover) x 100
(ROCE) Return on Capital Employed
This financial ratio assesses profitability relative to the total capital invested in a business.
ROCE = Profit before Interest and Tax (PBIT) / Total Capital Employed (TCE)
Return on Equity (ROE)
ROE is a financial ratio that measures management’s profitability by dividing net income by shareholder equity.
Formula: ROE = (Profit after Taxation – Preference Dividends) / Ordinary Shareholder’s Fund x 100
Earnings per Share
A company’s profit or net earnings are divided by the total number of outstanding shares to arrive at earnings per share (EPS). The writing reads as:
EPS = (Earnings after Taxation – Preference Dividends) / Number of Ordinary Shares
Investors use various ratios, including EPS, to maximize profits and analyze risks before investing in a company. The process of analyzing financial statements is made easier by these ratios, which make comparisons and future growth predictions of a company simple.
Business Risk Ratios
Business risk ratios are focused on the company’s risk. This involves evaluating how susceptible the company’s earnings are too fixed costs and debt obligations recorded on the balance sheet.
Operating Leverage
Operating leverage measures the impact of sales changes on operating profit, with companies with higher fixed costs being more vulnerable to fluctuations in revenue.
The formula for Operating Leverage = % Change in EBIT /% Change in Sales
Financial Leverage
Financial leverage is a metric that measures the responsiveness of net income to fluctuations in operating profit. It is calculated by comparing the percentage change in net profit to that of operating profit. Essentially, a company’s financial decisions, such as its use of debt, can influence its financial leverage.
The formula for Financial Leverage =% Change in Net Income /% Change in EBIT
Total Leverage
Total leverage measures the impact of sales changes on net profit, calculated as the percentage change in net profit compared to sales. This metric evaluates the extent to which net income is affected by fluctuations in revenue.
The formula for Total Leverage = % Change in Net Profit /% Change in Sales
Financial Risk Ratio Analysis
The financial risk ratio is the fifth class of financial ratios. It evaluates the company’s leverage and its ability to repay debt.
Debt Equity Ratio
The formula for Debt Equity is Long-Term Debts / Shareholder’s Fund
The calculation of equity required to repay debt can be a lengthy process.
Interest Coverage Ratio Analysis
The interest coverage ratio measures a company’s capacity to make interest payments on its debt. A greater ability to pay interest is indicated by a larger ratio. When the interest coverage ratio is lower than 1, it signifies that the company’s EBITDA is insufficient to satisfy its interest obligations, necessitating the use of additional sources of funding. The formula of Interest Coverage is EBITDA / Interest Expense
Debt Service Coverage Ratio
The financial analysis measures a company’s operating income to determine whether it is enough to cover its debt obligations for a year using the debt service coverage ratio (DSCR). Formula: Operating Income / Debt Service = Debt Service Coverage EBIT = Operating Income Principal, interest, and lease payments are all added up to create debt service. A DSCR of 1.0 indicates negative cash flows and insufficient operating cash flows to pay down debt.
Stability Ratios
The stability ratio, which measures a company’s long-term stability, is the sixth category of financial ratios. This ratio can be calculated using various methods and is used to evaluate a company’s sustainability over the long term.
Fixed Asset Ratio
To meet long-term business requirements, this ratio can be used to assess if the company is having fun or not.
The formula for Fixed Asset Ratio = Fixed Assets / Capital Employed
0.67 is the optimal ratio. If the ratio is less than one, it can be used to purchase fixed assets.
Current Assets to Fixed Assets Ratio
Current Assets / Fixed Assets = Ratio to Current Assets to Fixed Assets
An increase in this ratio indicates business expansion and higher profits, while a decrease suggests poor trading conditions.
Proprietary Ratio
The proprietary ratio describes a company’s financial strength by comparing shareholder funds to total tangible assets. The ratio should ideally be 1:3.
Shareholder Fund / Total Tangible Assets are the proprietary ratio formula.
Coverage Ratios
The seventh category of financial ratio analysis uses the coverage ratio to determine whether dividends or interest are due to investors or lenders. A larger coverage ratio is preferable since it shows that the business can readily satisfy its obligations.
Fixed Interest Cover
It evaluates a company’s financial performance and loan repayment capacity.
Net Profit before Interest and Taxes / Interest Charge is the formula for the fixed interest cover.
Fixed Dividend Cover
The number of dividends that must be paid to the investor can be calculated.
Net Profit before Interest and Taxes / Dividend on Preference is the formula for the fixed dividend cover.
Control Ratio Analysis
The control ratio is part of the seventh category of financial ratio analysis. It is used to evaluate the extent of management’s control over the company’s operations. This ratio analysis helps management assess whether the company’s performance is satisfactory or needs improvement.
Capacity Ratio
The formula below can be used for this kind of ratio analysis.
The formula for Capacity Ratio: Actual Hourly Worked Hours / Budgeted Hour * 100
Activity Ratio
One can use the formula to determine the measure of activity shown below:
The formula for Activity Ratio: Actual Production Standard Hours / Budgeted Standard Hour * 100
Efficiency Ratio
A favorable ratio is 100% or higher; an unfavorable ratio is less than 100%.
The Efficiency Ratio Formula is calculated by dividing Standard Hours for Actual Production by Actual Hours Worked and multiplying the result by 100.
Differences among Financial Ratios, Financial Ratio Analysis, and Ratio Analysis
| Aspect | Financial Ratios | Financial Ratio Analysis | Ratio Analysis |
|---|---|---|---|
| Definition | Financial statements are used to calculate quantitative measurements. | Financial ratios are calculated and compared by analyzing financial statements. | Using ratios or other quantitative measurements to analyze any form of data. |
| Focus | Financial information | Financial information | Any kind of data |
| Purpose | Examine many areas of a company’s financial health and performance | Examine the financial health and performance of an organisation. | Analyse several facets of a business. |
| Types of Ratios | Liquidity ratios, profit margins, solvency ratios, and so on. | Financial, non-financial, and performance ratios, for example. | Financial, non-financial, and performance ratios, for example. |
| Example Ratios | Current ratios, debt-to-equity ratio, returns on assets, and so on are all examples of financial ratios. | Customer satisfaction, employee turnover, market share, and so on. | Customer satisfaction, employee turnover, market share, and so on. |
| Application | Financial analyses, investment decisions, and loan decisions al use this term. | Financial analyses, investment decisions, and loan decisions all use this term. | Used in many different corporate scenarios, including marketing, operations, and human resources. |
| Scope | Financial data and financial analysis are the only things available. | Data can comprise both financial and non-financial information, as well as a variety of analysis methods. | Data can comprise both financial and non-financial information, as well as a variety of analysis methods. |
Locating Industry Financial ratios for Business Analysis
Organizations employ financial ratio to evaluate their performance in comparison to industry benchmarks or other businesses. Insights regarding their financial situation, stock price, profitability, and other factors can be gained thanks to this. Any size of business owner can evaluate their performance by looking at financial ratios and utilizing the information to enhance important areas of their operation and boost income. Financial ratios for numerous sectors and industries are available on numerous websites and corporate databases.
Factiva
Users can access the most recent business trends, market insights, and presentation-ready charts with Factiva , a sizable global library of news and licensed material. By creating an account and selecting the Companies & Markets page, users can quickly obtain industry financial ratios by selecting either the Industry Averages and Ratios option or the Ratio Comparison Report option.
Standard and Poor’s Net Benefit
A sizable corporate database called Net Advantage by Standard and Poor’s provides industry resources such as stock reports, financial data, survey results, and bond reports. The University of Connecticut and Proctor Library are only a couple of the third-party databases that customers of this service have access to. Search for a firm or industry from the Markets menu, then select Financial Operating Metrics or Key Stats & Ratios to get industry financial ratios. Enter the name of the company and choose Key Stats or Ratios from the menu to conduct particular company research.
Mergent
With almost a century of experience, Mergent provides research data, company actions, analytics, and critical financial statistics. You must register for Mergent Online or Mergent Intellect to access industry financial ratios. Select Company Benchmark Trends from the Financial Information page for Mergent Intellect, then click the Company Financials tab for Mergent Online. Once there, click financial ratios and then choose First Research industry reports.
RMA-The Risk Management Association
RMA provides market information based on customer financial reports from member institutions. Financial ratios can be found in the annual report or on the company website. Information from more than 260,000 financial reports from 780 different sectors is included in the Annual Statement Studies. Banks and other private lenders evaluate credit applications using these facts.
Dun & Bradstreet
For more than 175 years, significant businesses and global corporations have trusted the data provided by Dun & Bradstreet .They have information on more than 285 million organizations globally in their huge database. Users can quickly access 14 crucial business ratios for more than 800 different sorts of businesses across numerous industries with the help of their Key Business Ratios on the Web service.
Reuters
A significant business database called REUTERS offers vital corporate, market, and pricing information. Visit the Financial part of their website to get the financial ratios for the industry. To contact an agent and request the needed information, click Request Details or register for a user account.
Bizstats
Accurate financial ratios are available for free through the business database Bizstats . Visit the firm website and choose the “Search for industry financial benchmark reports” option to find the reports. Then, select the industry that interests you and either Sole Proprietorships or Corporations.
Local Sources
You can get in touch with your industry’s trade group or the neighborhood Chamber of Commerce to uncover financial ratios. However, it’s advised to use a subscription service if you’re looking for industry statistics and trends outside of your immediate area. Financial ratio databases like Bloomberg, Bizminer, OneSource, and the Yahoo Industry Centre are available to business owners. The organization’s specific needs and objectives determine the service option..
Advantages & Disadvantages of Financial ratios
Before depending only on financial measurements for company research, it is critical to weigh their advantages and disadvantages.
 Pros of Financial Ratios |  Cons of Financial Ratios |
|---|---|
| Provide quick and simple insights about a company’s financial health.This ratio can be utilized to compare a company’s performance against industry benchmarks.Financial ratios provide a means to identify trends and changes in a company’s financial performance over time. This assists investors and lenders in making well-informed decisions about investing in or lending to a company.Management can use this tool to identify areas where a company’s operations can be improved.For a more thorough understanding of a company’s financial status, it can be supplemented with other types of analysis, such as qualitative analysis. | The quality and accuracy of financial accounts are constraints.Accounting techniques can have an impact, making it difficult to compare organizations across industries.One-time events or market movements can skew results. Can oversimplify complex financial issues and neglect qualitative elements.It is possible that not all significant aspects that contribute to a company’s success or failure are captured.An in-depth knowledge of financial concepts and analysis techniques is necessary for effective utilization. |
Example of Budgeting
To increase the overall profitability of the business, the board of directors at XYZ Corporation sets a new goal for the marketing team: to sell 10,000 units at a discounted price during the fiscal year. The manufacturing division, however, is unable to produce 10,000 units in the allotted amount of time. The marketingand production divisions may become frequently at odds as a result of this circumstance. This problem may have been avoided if inputs from the production unit had been considered throughout the financial planning process.
Conversely, the sales team would anticipate a pay raise or performance-based bonuses if the marketingteam had successfully met the sales objective. Unfortunately, the planned incentives were not given because of the decreased output volume. As a result, the management could need to increase the amount of money set aside for pay without also increasing income. Organizations must have comprehensive budgets that connect and synchronize several departments for this reason alone.
Pros and Cons of Budgeting
| Pros | Cons |
|---|---|
| Enhanced planning and oversightOptimal allocation of resourcesImproved teamwork and coordinationHeightened employee motivationFacilitates forecasting and goal-settingStreamlines decision-makingPromotes responsibility and ownershipAssists in industry benchmarkingEnhances financial reportingDrives profitability | Lack of flexibilityTime-intensivePotential for conflictsSetting unrealistic targetsNeglecting external factorsImposing rigid constraintsComplexity Potential divergence from realityLimitations in suitabilityFocus on short-term gains. |
In a Nutshell
Financial ratios are useful in understanding financial markets. To gain a clear understanding of financial markets, including quick ratios, financial modeling, and financial advisor, visit our Trading Critique Website to proceed further.
FAQs – Frequently Asked Questions
1.What impact does financial ratio analysis have on a business?
Financial ratio analysis is used by businesses to detect potential risks as well as chances for profit. The financial ratios listed below are some of the most regularly employed in this study.
Financial ratios can assist in estimating the level of risk associated with investing in a company.
2.In the stock market, how is the financial ratio used?
The stock market has become one of the most popular markets in this generation, with a majority of companies being listed on the stock exchange. Financial ratios play a crucial role in the stock market, as they help investors predict the state of the market, how long it will last, and its current condition. By providing a record of spending and purchasing shares, financial ratios are essential in understanding the overall status of the market and can be highly beneficial to investors.
3.In what ways can financial ratios be advantageous to different sectors of the economy?
Financial ratios are universally useful as they simplify the computation of financial statements and balance sheets for businesses. Consequently, financial ratios are the exclusive metrics for measuring all financial information. Keeping track of business sector records is crucial for the advancement of an economy, whether it be a small business, large corporation, or industry. Such sectors play a significant role in improving a country’s economic situation.
4.Can financial ratios sometimes provide misleading information about a company’s performance?
While ratios can be useful in comparing companies in the same industry, they may overlook qualitative factors such as the value of a company’s human capital. While financial ratios generally provide helpful insights, there may be cases where they could be misleading. However, such cases are relatively rare.
