What Are Financial Ratios?
Before investing in a stock or company, it is crucial that you have a good understanding of what that company does and how is it performing financially. While analyzing and understanding the financial state of a company may seem like a challenging task, with the right knowledge and information, anyone can get a good idea of how a company is performing and what is the condition of its financial health.
Analyzing stocks and companies fundamentally is a great way to ensure that your money is invested in a stable and well-managed company. This allows your investment to grow consistently and generate high returns in the long run. One such way of fundamentally analyzing companies is by using financial ratios. In this article, we will explore the world of financial ratios and understand them from the basics. So, let’s get started!
Financial ratios, also known as accounting ratios are a quantitative analysis tool used by business managers and investors to gather valuable information from a company’s profitability, liquidity, leverage, solvency, efficiency, margins, rates of return, growth, and market valuation. This ratio analysis helps provide information to company owners and investors by examining the data contained in the company’s balance sheet, income statement, and statement cash flows.
The information collected from these financial ratios is critical to company owners who make financial decisions for the company and their investors. This analysis helps with the evaluation of the company’s financial status.
Meaning of Financial Ratios?
Financial ratios are practical tools that assist companies and investors examine and make comparisons between their financial relationships and the accounts on the company’s financial statements. It is a tool that makes financial examinations possible across a company’s history, an industry, or a business sector.
Company owners and their management usually use the data analysis collected from the calculation of these ratios to make proper decisions about improving the company’s profitability, liquidity, and solvency.
Types of Financial Ratios and Their Uses
Categorically speaking, there are six financial ratios that company owners use for their examinations and under these six categories, lie 15 financial ratios that also help company owners and investors examine the financial status of the company. These financial ratios can only be beneficial if there is a foundation of comparison for them.
Each of these ratios is expected to gain comparisons of the past periods of data for the company. They also get to be compared to data for other companies in the same industry. Below are the detailed types of financial ratios and how company owners and investors use them.
1. Liquidity Ratios
Liquidity ratios determine whether a company can meet its current debt obligations with its current assets. Under these liquidity ratios, there are three major ratios that company owners use:
- Working Capital Ratio: (Current Assets minus Current Liabilities) The Working Capital Ratio, also known as the Current ratio, is a figure that is calculated from the company’s balance sheet and used to measure whether the company can offset its short-term debt obligations with its current assets.
- Quick Ratio: (Current Assets minus Inventory divided by Current Liabilities) Also known as acid test ratio, this is a figure that is also calculated from the balance sheet of a company and used to measure whether the company can meet its short-term debt obligations without selling any inventory.
- Cash Ratio: (Cash plus Cash Equivalents divided by Current Liabilities) This liquidity ratio offers the company’s finance manager a more careful view of the company’s liquidity since it makes use of only cash and cash equivalents such as short-term marketable securities, while in the numerator. This ratio shows the ability of the company to offset all its current liabilities without liquidating any other assets.
2. Efficiency Ratios
The efficiency ratio is also known as the management ratio or activity ratio. It is used to determine how efficiently the company uses its assets to create sales and maximize profits or shareholder wealth. It also measures how efficient the company’s operations are on the inside and in their short-term. Under the efficiency ratio, four common ratios can be calculated with the information gathered from the balance sheet and income statement. They are:
- Inventory Turnover Ratio: (Sales divided by Inventory) This inventory turnover ratio measures how quickly inventories are sold and restocked or turned over each year. It allows the company’s finance manager to check if the company is sticking out of inventory or holding onto an outdated inventory.
- Fixed Assets Turnover Ratio: (Sales divided by Net Fixed Assets) The Fixed Assets Turnover ratio is a ratio that places its focus on the company’s plant, properties, and equipment or fixed assets, to assess how efficient the company makes uses of the assets.
- Total Assets Turnover Ratio: (Sales divided by Total Assets) The Total Asset Turnover ratio turns the evidence of the company’s efficient use of its asset base into a single ratio. It gives the company’s financial manager the authority to examine how efficiently its asset base is in creating sales and profitability.
- Days Sales Outstanding: (Accounts Receivable divided by Average Sales Per Day) Also known as the average collection period, the Days Sales Outstanding is a ratio that permits the company’s financial manager to assess the efficiency with which the company collects its outstanding credit accounts.
3. Solvency Ratios
A company’s solvency or debt management ratios allow the company’s financial manager to sum up the position of the company with regards to its debt financing, or financial leverage they use to finance their operations. The solvency ratios ascertain how much debt financing the company uses, compared to either of its retained earnings or equity financing. Here are two major solvency ratios:
- Debt-To-Equity Ratio: (Total Liabilities divided by Total Assets minus Total Liabilities) The debt-to-equity ratio is the most important ratio if the company is under public trade. The data it gets from this ratio is the same as from its total debt ratio. But it shows the data in a form that investors can willingly make use of when examining the business.
- Total Debt Ratio: (Total Liabilities divided by Total Assets) This total debt ratio measures the percentage of funds for the company’s operations gathered by a combination of its current liabilities plus its long-term debt.
4. Coverage Ratios
This ratio measures the extent to which the company can cover its debt obligations and meet its related costs. The obligations include interest expenses, lease payments, and sometimes, dividend payments. These ratios work with the solvency ratios to offer the company’s financial manager a complete picture of the company’s debt position. The two major coverage ratios are:
- Debt Service Coverage Ratio: (Net Operating Income divided by Total Debt Service Charges) This is a worthy summary ratio that offers the company the idea of how efficiently the company can cover all of its debt service obligations.
- Times Interest Earned Ratio: (Earnings Before Interest and Taxes (EBIT) divided by Interest Expenses) This ratio measures how efficiently a company can check its total debt or cover its interest payments debts on debt.
5. Profitability Ratios
This ratio is a concise ratio for the company that when calculated, sums up the effects of liquidity management, asset management, and debt management on the company. There are four primary profitability ratios and they are the following:
- Return on Total Assets (ROA): (Net Income divided by Sales) The ROA shows how well every dollar made from total assets brings profit for the company.
- Basic Earning Power (BEP): (Earnings Before Interest and Taxes (EBIT) divided by Total Assets) The BEP is the same as the ROA ratio because it measures the organization of assets in creating sales. More so, the basic earning power ratio allows the measurement free of the influence of taxes and debts.
- Net Profit Margin: (Net Income divided by Sales) This ratio indicates the profit per dollar of sales for the company.
- Return of Equity (ROE): (Net Income divided by Common Equity) This ratio shows how much money shareholders make on their investment in the company. The Return of Equity (ROE) is very important for companies that are traded publicly.
6. Market Value Ratios
The market value ratio is usually calculated for companies that are public and rarely used for small businesses. Here are the three primary market value ratios:
- Market/Book Ratio: (Stock Price divided by Book Value Per Share) This ratio allows the company’s financial manager another indication of how its investors view the value of its business firm.
- Price/Earnings Ratio (P/E): (Stock Price Per Share divided by Earnings Per Share) The P/E ratio indicates how much investors are ready to offset for the stock of the company per dollar of profits.
- Price/Cash Flow Ratio: (Stock Price divided by Cash Flow Per Share) A company’s value lies on its free cash flows. The price/cash flow ratio rates how efficiently the company creates cash flow.
How Do Financial Ratios Work?
Financial ratios are used to collect data from the company’s financial statements that cannot be assessed simply from analyzing the statements. Small companies can organize their spreadsheet to automatically calculate each of the 15 financial ratios. Generally, ratios are calculated for either a quarter or a calendar year. The ratios of other companies in that same industry should be arranged and then comparisons should take place.
It is after making the comparison of the company’s ratios to the companies in the same industry and with other timeframes, that the company’s financial manager or an investor can draw out a conclusion about the company’s performance. They can get a clearer picture of the company’s performances based on the calculations and comparisons they derive from their analysis.
A one-off ratio calculation does not give much data on its own. I.E, if a company’s debt-to-asset ratio for some time is 50%, it does not show a useful analysis unless the management compares it to older periods, particularly if the debt-to-asset ratio is much lower or higher factually. In this event, the debt-to-asset ratio tells us that 50% of the company’s assets are financed by debt.
Unless the company’s financial manager or an investor compares the same ratio from old company history or to the company’s competitors, they may never know if it is good or bad. There are other financial techniques also that a company’s financial manager can use to add to the knowledge gained through financial ratios. These include common size analysis and a more in-depth analysis of the statement of cash flows.
Users of Financial Ratios
Several stakeholders might need to make use of financial ratios. These stakeholders include:
- Financial Managers: They are required to have the data that the financial ratios convey about the performance of the various financial functions and sectors of the company.
- Competitors: Other companies and competitors get to know about the information of various companies in their industry as this important for them to enhance their competitive strategy.
- Investors: For companies that are traded publicly or companies that are financed by venture capital, potential investors need the financial data obtained from ratio analysis to ascertain whether or not they want to invest in the company.
Advantages of Using Financial Ratios
- Helps in setting up a goal for high performance: It is through financial ratios that the financial manager can ascertain an acceptable financial performance for the company. The company can get to see its real performance by checking its performance across time and perspire for a better performance by taking a look at its industry leader’s financial information.
- Useful for small organizations with thin focus or divisions of large organizations: While large multidivisional organizations might not use some of the financial ratios in their analysis, it is the smaller organizations with one line of business or the divisions of big organizations that find ratio analysis useful to them because of its comparisons to industry or company’s financial information.
- It is used to examine a company’s performance across different periods: The time-series or trend financial ratio allows organizations to assess their financial performance across different periods such as in a quarter or a calendar year.
- It is used to compare organizations on an across-the-board or industry basis: In a competitive realm, the comparisons of organizations’ financial performance to a group of similar organizations within an industry helps the financial manager see where it stands.
Disadvantages of the Use of Financial Ratios
- Ratios are generally not used for large, multidivisional organizations: Because ratio analysis is only useful on a comparison basis, the divisions of large organizations can make use of its financial analysis technique, but will not be useful to a large – multidivisional company.
- Problems may arise if there is an increment: Once a company operates in an environment with constant increases and volatility, financial data will be deformed from one-time period to another and ratios will not be meaningful.
- Disguise: Organizations can cheat and disguise their financial statements. Disguise is the act of making financial reports look legit but faking data in order to maintain the company image in the industry.
- Seasonal and cyclical organizations: If organizations are found to have seasonal or cyclical sales, the financial ratio using the time-series data would yield deformed results since the sales vary largely between periods.
Financial ratios are strong analytical tools of financial analysis that give a company and potential investors a clear and concise picture of its financial performance on both trend and an industry basis. However, ratios can only be useful if the data is compared over various time periods or with other companies in the industry. All of the information obtained from a company’s financial statements using ratio analysis is useful to both the managers, the competitors, and the investors. We hope that this article provided you with interesting and valuable information, which in turn will help you make better investment decisions. If you would like to see more such interesting content on the financial markets, then do check out Jeremy’s YouTube Channel “Financial Education”. Happy Investing!