Financial Ratios
Financial Ratios are calculations used to analyze a company's financial performance and assess its financial health. They provide insights into various aspects of a company's operations, profitability, liquidity, solvency, and efficiency. Financial ratios are calculated using information from a company's financial statements, such as the balance sheet, income statement, and cash flow statement. In other words, financial ratios are measurements used to determine how healthy a business is.
There are several categories of financial ratios, including:
- Profitability Ratios: These ratios measure a company's ability to generate profits and earn a return on its investments. Examples include gross profit margin, net profit margin, return on assets, and return on equity.
- Liquidity Ratios: These ratios assess a company's ability to meet its short-term obligations and manage its cash flow. Examples include the current ratio, quick ratio, and cash ratio.
- Solvency Ratios: These ratios evaluate a company's long-term financial stability and its ability to meet its long-term obligations. Examples include the debt-to-equity ratio, debt ratio, and interest coverage ratio.
- Efficiency Ratios: These ratios measure a company's operational efficiency and how effectively it uses its resources. Examples include inventory turnover ratio, accounts receivable turnover ratio, and asset turnover ratio.
- Market Ratios: These ratios reflect the market's perception of a company's value and its attractiveness to investors. Examples include price-to-earnings ratio, price-to-sales ratio, and market-to-book ratio.
Each financial ratio provides valuable information about a company's financial performance and position. By analyzing these ratios over time and comparing them to industry benchmarks or competitors, investors, analysts, and stakeholders can gain insights to make informed decisions and assess the company's creditworthiness, profitability, and overall financial health.
Financial Ratios Video
Common Financial Ratio Calculations (formulas) are listed below:
Profitability
Gross Profit Margin
Gross profit margin is a profitability ratio that measures the percentage of revenue left after subtracting the cost of goods sold. Gross profit margin is a measure of profitability..
GROSS PROFIT MARGIN = (REVENUE - COST OF SALES) / REVENUE * 100
Net Profit Margin
Net profit margin is a also profitability ratio that measures the percentage of revenue and other income left after subtracting all costs for the business, including costs of goods sold, operating
expenses, interest, and taxes. .
NET PROFIT MARGIN = NET PROFIT / REVENUE * 100
Return on Equity
Return on equity, more commonly displayed as ROE, is a profitability ratio measured by dividing net profit by owner's equity. It indicates how well the business can utilize equity investments to earn profit for owners/investors.
ROE = NET PROFIT / (BEGINNING EQUITY + ENDING EQUITY) / 2
Return on Assets
Return on assets, or ROA, is another profitability ratio similar to ROE. It’s measured by dividing net profit by the company’saverage assets. It’s an indicator of how well the company is managing its available resources and assets to net higher profits.
ROA = NET PROFIT / (BEGINNING TOTAL ASSETS + ENDING TOTAL ASSETS) /2
Liquidity
Working Capital
Working capital is a measure of the business’s available operating liquidity.
WORKING CAPITAL = CURRENT ASSETS - CURRENT LIABILITIES
Current Ratio
Current ratio is a liquidity ratio that helps determine whether the business can pay its short-term liabilities using its current assets.
CURRENT RATIO = CURRENT ASSETS / CURRENT LIABILITIES
Quick Ratio
The quick ratio, also known as an acid test ratio, is another type of liquidity ratio that measures a business’s ability pay its short-term liabilities. The quick ratio uses only highly liquid current assets in its numerator, such as cash, marketable securities, and accounts receivables that are readily convertible into cash.
QUICK RATIO = (CURRENT ASSETS - INVENTORY) / CURRENT LIABILITIES
Solvency
Financial leverage, also known as the equity multiplier, refers to the use of debt to buy assets. If all the assets are financed by equity, the multiplier is one. As debt increases, the multiplier increases from one, demonstrating the leverage impact of the debt and, ultimately, increasing the business risk.
LEVERAGE = TOTAL ASSETS / TOTAL EQUITY
Debt-to-Equity Ratio
The debt-to-equity ratio is a solvency ratio that measures how much a company finances itself using equity versus debt.This ratio provides insight into the solvency of the business by reflecting the ability of shareholder equity to cover all debt in the event of a business downturn.
DEBT-TO-EQUITY RATIO = TOTAL DEBT / TOTAL EQUITY
Efficiency
Inventory Turnover
Inventory turnover is an efficiency ratio that measures how many times per accounting period the company sold its entire inventory. It gives insight into whether a company has excessive inventory relative to its sales levels.
INVENTORY TURNOVER =
COST OF GOODS SOLD / (BEGINNING INVENTORY + ENDING INVENTORY) / 2
Total Asset Turnover
Total asset turnover is a ratio that measures how efficiently a company uses its assets to generate revenue. The higher the turnover ratio, the better the company’s performance.
TOTAL ASSET TURNOVER =
REVENUE / (BEGINNING TOTAL ASSETS + ENDING TOTAL ASSETS) / 2
Financial Ratio Formulas (Calculations)
We discussed earlier the common financial ratios. Here we list additional ratios to aid you in analyzing your financial statements and briefly explain what they measure.
Financial Ratio Formulas (Calculations)
We discussed earlier the common financial ratios. Here we list additional ratios to aid you in analyzing your financial statements and briefly explain what they measure..
Activity Ratios
- Receivables turnover = Annual sales/ Average receivables - The efficiency of a company in collecting its trade receivables
- Days of sales outstanding = 365 / Receivables turnover - The average number of days a company takes to collect its receivables from clients
- Inventory turnover = Cost of goods sold / Average inventory - The efficiency of a company in terms of inventory management
- Days of inventory on hand = 365 / Inventory turnover - The average inventory processing period
- Payables turnover = Purchases /Average trade payables - The efficiency of a company in allowing trade credit to suppliers
- Number of days of payables = 365 / Payables turnover ratio - The average number of days a company takes to pay its suppliers
- Fixed assets turnover = Revenue / Average net fixed assets - The efficiency of a firm in utilizing its fixed assets
- Working capital turnover = Revenue / Average working capital - The efficiency of a firm in managing its working capital (current assets - current liabilities)
- Total assets turnover = Revenue / Average total assets - The efficiency of a firm in using its total assets to create revenue
- Cash conversion cycle = Days of sales outstanding +Days of inventory on hand - Number of days of payables - The number of days a company takes to convert its investments in inventory and other resources into cash flows from sales
- Equity turnover = Revenue / Average total equity - The efficiency of a firm in utilizing equity to create revenue
Liquidity Ratios
- Current ratio = Current assets / Current liabilities - Ability to meet current liabilities (with current assets)
- Quick ratio = (Cash + Marketable securities + Receivables) / Current liabilities - Ability to meet current liabilities (with total current assets, excluding inventory)
- Cash ratio = (Cash + Marketable securities) / Current liabilities - Ability to meet current liabilities (with cash and marketable securities only)
- Defensive= interval = (Cash + Marketable securities + Receivables) / Average daily expenditure - The number of days a company can cover its average daily expenses with the use of current liquid assets only
Solvency Ratios
- Debt-to-equity = Total debt / Total equity - Debt as a percentage of total equity
- Debt-to-capital = Total debt / (Total debt + Total equity) - Debt as a percentage of total capital
- Debt-to-assets = Total debt / Total assets - Debt as a percentage of total assets
- Financial leverage = Average total assets / Average total equity - An indicator of a company’s debt financing usage
- Interest coverage = Earnings before interest and taxes / Interest payments - The ability to cover interest expenses
- Fixed charge coverage = (Earnings before interest and taxes + Lease payments coverage) / (Interest payments + Lease payments) - The ability to cover interest and lease expenses
Profitability Ratios
- Gross profit margin = Gross profit / Revenue - Gross profitability as a percentage of total revenue
- Operating income EBIT(Earnings Before Interest & Taxes) = Operating profit margin / Revenue - Operating profitability (before interest and tax) as a percentage of total revenue
- Pre-tax margin = EBT(Earnings Before Taxes) / Revenue - Operating profitability (before tax) as a percentage of total revenue
- Net profit margin = Net income / Revenue - Net profitability as a percentage of total revenue
- Return on assets (ROA) = Net income / Average total assets - Net profitability (excluding interest and taxes) as a percentage of total invested funds
- Operating return on assets (ROA) = Operating profit EBIT (Earnings Before Taxes) / Average total assets - Net profitability (including interest and taxes) as a percentage of total invested fund
- Return on total capital = Operating profit EBIT(Earnings Before Taxes) / Average total capital - Operating profitability as a percentage of total capital
- Return on Equity (ROE) = Net income / Average equity - Net profitability as a percentage of total equity
To learn more about financial ratios check out my Financial Statements Analysis Tutorial or download my Ratios PDF.
Financial Statements Analysis PDF (Click the Arrow to download)
Additional Financial Statements Analysis & Ratios Videos