What Is a Financial Ratio?

Financial ratios are used to analyse a company’s financial statements and show its financial standing in terms of trends in the firm or in comparison with other firms. They help investors, creditors and the management of a company to know how well a company is performing and the areas that need improvements. Ratios are also used to compare different companies across industries, both big and small and identify their financial strengths and weaknesses.

Financial ratios are categorized into:

1. Profitability Ratios

They show a company’s ability to make profits from its operations and whether a company is making enough operational profits from its assets. They also measure the management’s effectiveness as shown by returns generated on sales and investment.

They are:

a) Gross Margin

This measures how profitable a company can sell its inventory. The higher the gross profit margin the better, as this means that the company is selling its inventory at higher profit percentage.

Gross Margin= Gross profit   x 100

Sales

b) Operating Margin

This indicates efficiency with which costs have been controlled in generating profit from sales.

Operating Margin = Operating profit/Profit before interest and tax  x 100

Sales

c) Net Profit Margin

This measures firm’s ability to control its production, operating and financing costs.

Net Profit Margin = Net profit x 100

                  Sales

d) Return on Assets (ROA)

This measures how effectively a firm’s assets are being used to generate profit.

Return on Assets = Net Income

                                     Total Assets

e) Return on Equity (ROE)

This measures the ability of a company to generate profits from its shareholders investments in the company. Investors want to see a high return on equity ratio because this indicates that the company is using its investors' funds effectively.

Return on Equity = Net Income

                                       Shareholder’s Equity

f) Return on Investment (ROI)

This measures the efficiency with which a company uses its total funds in capital employed to generate returns to owner’s funds.

Return on Investment = Profit after tax        x 100

                                                                                      Capital employed

g) Return on Capital Employed (ROCE)

This measures the efficiency with which a company uses long term funds or permanent assets to generate returns to shareholders.

ROCE = Profit before interest and tax / Operating profit

Capital Employed

Whereby , Capital employed=fixed assets plus net working capital.

 

2. Liquidity Ratios

They show a company’s ability to meet its short term obligations. They also show the cash levels of a company and the ability to turn other assets into cash to pay off liabilities and other current obligations.

They are:

a) Current Ratio

This measures a firm's ability to pay off its short-term liabilities with its current assets. It helps investors and creditors understand the liquidity of a company and how easily that company will be able to pay off its current liabilities. A higher current ratio means the company can easily make current debt payments.

Current Ratio = Current Assets

                                    Current Liabilities

b) Quick Ratio/ Acid Test Ratio

This measures the liquidity of a company by showing its ability to pay off its current liabilities with quick assets. If a firm has enough quick assets to cover its total current liabilities, the firm will be able to pay off its obligations without having to sell off any long-term or capital assets.

Quick/Acid test = Current Assets – Inventory

                 Current Liabilities

 

3. Leverage/Gearing Ratios

They measure a company's ability to sustain operations indefinitely by comparing debt levels with equity, assets, and earnings. It also shows a company's ability to make payments and pay off its long-term obligations to creditors and banks. The higher the ratio, the higher the financial risk.

They are:

a) Debt Ratio

This shows a company's ability to pay off its liabilities with its assets and how many assets the company must sell in order to pay off all of its liabilities. A lower debt ratio usually implies a more stable business with the potential of longevity as the company has lower overall debt.

 

Debt Ratio = Total Liabilities

                 Total Assets

b) Debt to Equity Ratio

This shows the percentage of a company financing that comes from creditors and investors. A company with a higher debt to equity ratio is considered more risky to creditors and investors than companies with a lower ratio because it means that more debt financing is used than equity financing.

Debt to Equity Ratio = Total Liabilities

                                    Total Equity

c) Times Interest Cover/ Interest Coverage

This shows how well a company’s earning can cover interest payments on its debt. The higher the ratio, the lower the risk.

Interest Coverage = Earnings before interest and tax (EBIT)

Interest Expense

 

4. Activity/Efficiency Ratios

They measure how well companies utilize their assets to generate income.

They are:

a) Asset turnover

This measures a company's ability to generate sales from its assets.  Higher turnover ratios mean the company is using its assets more efficiently.

Asset Turnover = Net Sales

                               Average Total Assets

b) Receivables Turnover

This measures how many times a business can collect its average accounts receivable during the year. The higher the ratio, the more efficient management is in managing its credit policy.

Receivables Turnover = Credit Sales

                                              Average Receivables

c) Average Collection Period

This shows the approximate amount of time it takes a company to receive payments owed from its customers and clients.

Average Collection Period =              365

                                                                 Receivables Turnover

d) Inventory Turnover

This shows how many times inventory is turned converted into sales within a year.

Inventory Turnover = Cost of Sales

                                          Average Inventory

e) Inventory Conversion Period

This shows the approximate amount of time it takes a company to convert inventory into sales. The fewer the number of days, the more efficient a company is in converting inventory into sales.

Inventory Conversion Period =              365

                                                                Inventory Turnover

f) Creditors Turnover

This shows the number of times creditors are paid by a company during a financial year.

Creditors Turnover = Credit Purchases

                                      Average Payables or Creditors

g) Average Deferral Period

This shows the approximate period of time suppliers allow a company to settle its dues.

Average Deferral Period =            365

                                                     Creditors Turnover

h) Cash Working Cycle/ Working Capital Cycle

This shows the period of time that elapses between the point at which cash is spent on production or purchase of inventory to the time inventory is converted into cash or cash is collected from a customer.

Cash Working Cycle = Average Collection Period + Inventory Conversion Period – Average Deferral Period

i) Cash Turnover

This shows how many times a company has to replenish its working capital

Cash Turnover =                365

                                             Working Capital Cycle

 

5. Investment or Equity Ratios

They are used by investors to analyze the overall performance of a company by analysing stock price trends and help figure out a stock's current and future market value.

a) Earnings Per Share(EPS)

This indicates the amount shareholders expect to generate in form of earnings for every share invested. It shows the profitability of a company on a per share basis.

Earnings per Share = Earnings attributable to equity shareholders

         Number of Ordinary Shares

b) Dividends Per Share (DPS)

This shows the amount of cash dividend that share holders expect to receive for every share invested in the company.

Dividends per Share = Total Ordinary Dividends

                                             Number of Ordinary Shares

c) Dividend Payout Ratio

This indicates proportion of earnings attributable to equity shareholders that are paid out to common shareholders as dividends.

Dividend Payout Ratio = Dividends Per Share x   100

                                                                                    Earnings Per Share

d) Dividends Yield

This measures how much an investor expects to receive from cash dividends for every share purchased or invested in a company.

Dividend Yield = Dividends Per Share  x 100

                       Market Price per Share

e) Price Earnings Ratio

This indicates how much an investor is prepared to pay for a company’s share given its current earnings per share.

Price Earnings Ratio = Market Price per Share

                                  Earnings Per Share

 

Limitations of Financial Ratios

1. Difficult to compare between firms that have different according standards.
2. Information used for ratio analysis is based on historical information.
3. If rate of inflation changes during periods this means that the numbers are not comparable across periods
4. Difficult to interpret some of the ratios