Financial ratio
Introduction
A financial ratio is a mathematical relationship between two selected numerical values extracted from an enterprise's financial statements. Financial ratios are used by analysts, investors, and corporate management to evaluate the performance, financial health, and value of a company. They provide insights into various aspects of a company's operations, such as its efficiency, liquidity, profitability, and solvency.
Types of Financial Ratios
Financial ratios can be categorized into five main types: liquidity ratios, profitability ratios, efficiency ratios, leverage ratios, and market value ratios.
Liquidity Ratios
Liquidity ratios measure a company's ability to meet its short-term obligations. They provide information about a firm's capacity to pay off its debts as they come due without incurring unacceptable losses. The most commonly used liquidity ratios include the current ratio, quick ratio, and cash ratio.
Profitability Ratios
Profitability ratios assess a company's ability to generate earnings relative to its sales, assets, and equity. They show how well a company uses its resources to generate profit. Key profitability ratios include the gross margin ratio, operating margin ratio, net profit margin, return on assets (ROA), and return on equity (ROE).
Efficiency Ratios
Efficiency ratios, also known as activity ratios or asset utilization ratios, measure how effectively a company uses its assets and liabilities internally. These ratios include inventory turnover, receivables turnover, and asset turnover ratios.
Leverage Ratios
Leverage ratios indicate the proportion of debt used in a company's capital structure. They provide an understanding of the risk and return of a company's capital structure decisions. Common leverage ratios include the debt ratio, debt-equity ratio, and equity multiplier.
Market Value Ratios
Market value ratios are used to evaluate the share price of a company's stock. These ratios include the price-to-earnings (P/E) ratio, price-to-book (P/B) ratio, price-to-sales (P/S) ratio, dividend yield, and market capitalization.
Calculation and Interpretation of Financial Ratios
Financial ratios are calculated by dividing one financial metric by another. The resulting ratio can be interpreted in a relative sense, compared to historical data, industry averages, or even between firms in the same industry.
Liquidity Ratios
1. Current Ratio: The current ratio is calculated as current assets divided by current liabilities. A ratio greater than one indicates that the company has more assets than liabilities, suggesting good short-term financial health.
2. Quick Ratio: The quick ratio is calculated as (current assets - inventories) divided by current liabilities. It provides a more conservative view of a company's ability to meet its short-term liabilities.
3. Cash Ratio: The cash ratio is calculated as cash and cash equivalents divided by current liabilities. It measures a company's ability to pay off its current liabilities with just its cash and cash equivalents.
Profitability Ratios
1. Gross Margin Ratio: The gross margin ratio is calculated as gross profit divided by sales. It measures the percentage of sales revenue that exceeds the cost of goods sold.
2. Operating Margin Ratio: The operating margin ratio is calculated as operating income divided by sales. It shows the proportion of revenues that is available to cover non-operating expenses.
3. Net Profit Margin: The net profit margin is calculated as net income divided by sales. It measures the percentage of sales that turns into profits after all expenses are accounted for.
4. Return on Assets (ROA): ROA is calculated as net income divided by total assets. It measures how efficiently a company uses its assets to generate profits.
5. Return on Equity (ROE): ROE is calculated as net income divided by shareholders' equity. It measures the profitability of a company in relation to stockholders' equity.
Efficiency Ratios
1. Inventory Turnover: Inventory turnover is calculated as cost of goods sold divided by average inventory. It measures how many times a company sells and replaces its inventory during a period.
2. Receivables Turnover: Receivables turnover is calculated as net credit sales divided by average accounts receivable. It measures how efficiently a company uses its assets.
3. Asset Turnover: Asset turnover is calculated as net sales divided by average total assets. It measures a company's efficiency at using its assets to generate sales.
Leverage Ratios
1. Debt Ratio: The debt ratio is calculated as total debt divided by total assets. It measures the proportion of a company's assets that is financed by debt.
2. Debt-Equity Ratio: The debt-equity ratio is calculated as total debt divided by total equity. It measures the financial leverage of a company, indicating the proportion of debt used to finance the company's assets.
3. Equity Multiplier: The equity multiplier is calculated as total assets divided by total equity. It measures a company's financial leverage and indicates a company's strategy in using debt versus equity in its capital structure.
Market Value Ratios
1. Price-to-Earnings (P/E) Ratio: The P/E ratio is calculated as market price per share divided by earnings per share (EPS). It measures the price paid for a share relative to the annual net income earned by the firm per share.
2. Price-to-Book (P/B) Ratio: The P/B ratio is calculated as market price per share divided by book value per share. It compares a company's market value to its book value.
3. Price-to-Sales (P/S) Ratio: The P/S ratio is calculated as market capitalization divided by total sales over the past 12 months. It measures the value placed on each dollar of a company's sales or revenues.
4. Dividend Yield: The dividend yield is calculated as annual dividends per share divided by market price per share. It measures the dividend return on a company's stock.
5. Market Capitalization: Market capitalization is calculated as the total number of outstanding shares multiplied by the current market price of one share. It represents the total value of all a company's outstanding shares of stock.
Uses of Financial Ratios
Financial ratios are used by various stakeholders for different purposes:
1. Investors: Investors use financial ratios to compare the strengths and weaknesses of various investment opportunities and to monitor their investments' performance.
2. Creditors: Creditors use financial ratios to determine a company's creditworthiness and to make decisions about extending credit.
3. Management: Management uses financial ratios to monitor the company's performance and make strategic decisions about operations, such as pricing, inventory management, and investment in new assets.
4. Financial Analysts: Financial analysts use financial ratios to make predictions about a company's future performance and to make recommendations about the purchase or sale of a company's stock.
Limitations of Financial Ratios
While financial ratios can provide valuable insights into a company's financial health and performance, they also have limitations:
1. Lack of Comparability: Differences in accounting methods can make comparisons between companies difficult.
2. Not a Substitute for Financial Statements: Financial ratios are not a substitute for reviewing a company's financial statements.
3. Historical Information: Financial ratios are based on historical information and may not reflect a company's current or future performance.
4. No Single Ratio Tells the Whole Story: No single ratio can provide all the information needed to make a well-informed decision.
See Also
- Financial statement analysis
- Fundamental analysis
- Income statement
- Balance sheet
- Cash flow statement