The use of financial figures to gain significant information about a company Show Financial ratios are created with the use of numerical values taken from financial statements to gain meaningful information about a company. The numbers found on a company’s financial statements – balance sheet, income statement, and cash flow statement – are used to perform quantitative analysis and assess a company’s liquidity, leverage, growth, margins, profitability, rates of return, valuation, and more.  Financial ratios are grouped into the following categories:
Uses and Users of Financial Ratio AnalysisAnalysis of financial ratios serves two main purposes: 1. Track company performanceDetermining individual financial ratios per period and tracking the change in their values over time is done to spot trends that may be developing in a company. For example, an increasing debt-to-asset ratio may indicate that a company is overburdened with debt and may eventually be facing default risk. 2. Make comparative judgments regarding company performanceComparing financial ratios with that of major competitors is done to identify whether a company is performing better or worse than the industry average. For example, comparing the return on assets between companies helps an analyst or investor to determine which company is making the most efficient use of its assets. Users of financial ratios include parties external and internal to the company:
Liquidity RatiosLiquidity ratios are financial ratios that measure a company’s ability to repay both short- and long-term obligations. Common liquidity ratios include the following: The current ratio measures a company’s ability to pay off short-term liabilities with current assets: Current ratio = Current assets / Current liabilities The acid-test ratio measures a company’s ability to pay off short-term liabilities with quick assets: Acid-test ratio = Current assets – Inventories / Current liabilities The cash ratio measures a company’s ability to pay off short-term liabilities with cash and cash equivalents: Cash ratio = Cash and Cash equivalents / Current Liabilities The operating cash flow ratio is a measure of the number of times a company can pay off current liabilities with the cash generated in a given period: Operating cash flow ratio = Operating cash flow / Current liabilities Leverage Financial RatiosLeverage ratios measure the amount of capital that comes from debt. In other words, leverage financial ratios are used to evaluate a company’s debt levels. Common leverage ratios include the following: The debt ratio measures the relative amount of a company’s assets that are provided from debt: Debt ratio = Total liabilities / Total assets The debt to equity ratio calculates the weight of total debt and financial liabilities against shareholders’ equity: Debt to equity ratio = Total liabilities / Shareholder’s equity The interest coverage ratio shows how easily a company can pay its interest expenses: Interest coverage ratio = Operating income / Interest expenses The debt service coverage ratio reveals how easily a company can pay its debt obligations: Debt service coverage ratio = Operating income / Total debt service Efficiency RatiosEfficiency ratios, also known as activity financial ratios, are used to measure how well a company is utilizing its assets and resources. Common efficiency ratios include: The asset turnover ratio measures a company’s ability to generate sales from assets: Asset turnover ratio = Net sales / Average total assets The inventory turnover ratio measures how many times a company’s inventory is sold and replaced over a given period: Inventory turnover ratio = Cost of goods sold / Average inventory The accounts receivable turnover ratio measures how many times a company can turn receivables into cash over a given period: Receivables turnover ratio = Net credit sales / Average accounts receivable The days sales in inventory ratio measures the average number of days that a company holds on to inventory before selling it to customers: Days sales in inventory ratio = 365 days / Inventory turnover ratio Profitability RatiosProfitability ratios measure a company’s ability to generate income relative to revenue, balance sheet assets, operating costs, and equity. Common profitability financial ratios include the following: The gross margin ratio compares the gross profit of a company to its net sales to show how much profit a company makes after paying its cost of goods sold: Gross margin ratio = Gross profit / Net sales The operating margin ratio compares the operating income of a company to its net sales to determine operating efficiency: Operating margin ratio = Operating income / Net sales The return on assets ratio measures how efficiently a company is using its assets to generate profit: Return on assets ratio = Net income / Total assets The return on equity ratio measures how efficiently a company is using its equity to generate profit: Return on equity ratio = Net income / Shareholder’s equity Learn more about the different profitability ratios in the following video: Market value ratios are used to evaluate the share price of a company’s stock. Common market value ratios include the following: The book value per share ratio calculates the per-share value of a company based on the equity available to shareholders: Book value per share ratio = (Shareholder’s equity – Preferred equity) / Total common shares outstanding The dividend yield ratio measures the amount of dividends attributed to shareholders relative to the market value per share: Dividend yield ratio = Dividend per share / Share price The earnings per share ratio measures the amount of net income earned for each share outstanding: Earnings per share ratio = Net earnings / Total shares outstanding The price-earnings ratio compares a company’s share price to its earnings per share: Price-earnings ratio = Share price / Earnings per share Related ReadingsThank you for reading CFI’s guide to financial ratios. To help you advance your career in the financial services industry, check out the following additional CFI resources:
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Financial ratios are a helpful tool to analyse how your business is performing. Although they might not be as exciting as other aspects of your business – such as sales, marketing and product development – knowing your financial ratios will give quick insight into your company’s financial health.
Even if you hate accounting and think accountants are ‘bean counters’, running your business requires a basic understanding of some fundamental accounting principles. One of these fundamentals is financial ratios which can be helpful tools in understanding a company’s financial health. They are a benchmark by which you can compare your business to industry standards and analyse changes over time. By using financial ratios you can get a snapshot of your company’s health. Three of the most common types of ratios fall into the categories of liquidity, debt and profitability. Here we’ll take you through what each ratio shows you, and you can calculate them.
These financial ratios show a company’s ability to pay off short-term debt without raising additional capital. a. Operating cash flow ratio The operating cash flow shows the relation of cash flow that a company generates from operations to its current debt. This ratio shows how liquid a firm is in the short run since it connects current debt with cash flow from operations. Operating cash flow ratio = cash flow from operations ÷ current liabilities When the operating cash flow ratio is less than 1, the business is not generating sufficient cash to pay off its short-term debt. In this situation, the company might not be able to continue operating. b. Current ratio The current ratio measures a company’s ability to meet its short-term obligations. Current ratio = current assets ÷ current liabilities Current assets and liabilities are short-term assets and liabilities – it’s expected that current assets will be turned into cash and current liabilities paid within one year. For example, a company with current assets of $1,500,000 and current liabilities of $700,000 has a current ratio of 2.14. A current ratio of 2.0 is often seen as acceptable, but will depend on the industry. In general, the more liquid a company’s current assets, the smaller the current ratio can be without causing concern. c. Quick ratio The quick ratio (also called ‘acid test’) is similar to the current ratio but it doesn’t include inventory. Quick ratio = (current assets – inventory) ÷ current liabilities A quick ratio of 1 is sometimes recommended, but will vary between industries. When inventory cannot be easily converted into cash, the quick ratio provides a more accurate measure of overall liquidity. When a firm’s inventory is liquid, the current ratio is better for measuring liquidity.
These financial ratios show to what extent a business uses debt to fund its operations. a. Debt ratio The debt ratio measures the proportion of a firm’s total assets that are financed by its creditors. The higher the debt ratio, the more credit is being used by the firm. Debt ratio = total liabilities ÷ total assets For example, a company with $2,500,000 in total liabilities and $4,200,000 in total assets will have a debt ratio of 0.60, or 60 per cent. This debt ratio shows that 60 per cent of this company’s assets are financed with debt. Companies with high debt ratios are referred to as being ‘highly leveraged’. Anywhere between 0.3 and 0.6 can be considered a good debt ratio, depending on the industry. Debt ratios under 0.4 are considered to be a lower risk. b. Times interest earned ratio This ratio measures a company’s ability to make contractual interest payments. Times interest earned = earnings before interest and taxes ÷ interest The higher the times interest earned ratio, the greater the firm’s ability to meet interest payment obligations. For example, a company with earnings before interest and taxes of $1.9 million and annual interest obligations of $450,000 will have a times interest earned ratio of 4.2. A times interest earned ratio between 3.0 and 5.0 is considered to be acceptable in most cases.
These financial ratios indicate the ability of a business to generate profit relative to other factors. a. Gross profit margin This gross profit margin measures the percentage of profit remaining after the cost of goods – and not other expenses – have been paid. This ratio gives an indication of whether the average mark-up on goods and services is sufficient. The greater the gross margin, the more able a firm is to cover expenses and make a profit. Gross profit margin = (sales – cost of goods sold) ÷ sales = gross profits ÷ sales For example, a company with $6.5 million in sales and $4.7 million in cost of goods sold will have a gross margin of 28 per cent. b. Net profit margin The net profit margin measures the percentage of sales dollars remaining after the all expenses, including the cost of goods and taxes, have been paid. It is considered a key performance indicator of a firm’s success. Net profit margin = net profits after taxes ÷ sales. If a company has sales of $2.1 million and a net profit after taxes of $260,000, its net profit margin is 12 per cent. Acceptable net profit margins vary between industries. A net profit margin of 2 per cent is not unusual for a supermarket, while a software company might have a net profit margin of 25 per cent. Financial ratios can be an effective way to analyse your business performance over time and against industry averages. Your accountant can help you determine your financial ratios and how your business compares against standard benchmarks.
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What are a group of ratios that measure the ability of the business firm to pay off short term obligations as they mature called?
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