What are Financial Ratios?

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:

 Liquidity ratios
 Leverage ratios
 Efficiency ratios
 Profitability ratios
 Market value ratios

Uses and Users of Financial Ratio Analysis

Analysis of financial ratios serves two main purposes:

1. Track company performance:

Determining 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 performance

Comparing financial ratios with that of major competitors is done to identify whether the 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’s assets is being used most
efficiently.

Users of financial ratios include parties external and internal to the company:
  External users: Financial analysts, retail investors, creditors, competitors, tax authorities,
regulatory authorities, and industry observers
 Internal users: Management team, employees, and owners

Liquidity Ratios

Liquidity 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 Ratios

Leverage 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

Debt to equity ratio = Total liabilities / Shareholder’s equity

The interest coverage ratio determines how easily a company can pay its interest expenses:

Interest coverage ratio = Operating income / Interest expenses

The debt service coverage ratio determines how easily a company can pay its debt obligations:

Debt service coverage ratio = Operating income / Total debt service

Efficiency Ratios

Efficiency 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 / 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

Days sales in inventory ratio = 365 days / Inventory turnover ratio

Profitability Ratios

Profitability 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 off 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

Market Value Ratios

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 equity available to
shareholders:
 Book value per share ratio = Shareholder’s equity / Total 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 the earnings per share:

Price-earnings ratio = Share price / Earnings per share