A ratio, you will remember from school, is the relationship between two numbers.

As your math
teacher might have put it, it is “the relative size of two quantities, expressed as the quotient of
one divided by the other.”

What Is Financial Ratio Analysis?

Financial ratios are useful tools that help business managers and investors analyze and compare
financial relationships between the accounts on the firm's financial statements. They are one tool
that makes financial analysis possible across a firm's history, an industry, or a business sector.
Financial ratio analysis uses the data gathered from the calculation of the ratios to make decisions
about improving a firm's profitability, solvency, and liquidity.

What is a Ratio?

A ratio is a mathematical relation between one quantity and another. Suppose you have 200 apples
and 100 oranges. The ratio of apples to oranges is 200 / 100, which we can more conveniently
express as 2:1 or 2.
What is a Financial Ratio?
A financial ratio is a comparison between one bit of financial information and another. Consider
the ratio of current assets to current liabilities, which we refer to as the current ratio. This ratio is
a comparison between assets that can be readily turned into cash current assets and the
obligations that are due in the near future -current liabilities. A current ratio of 2:1 or 2 means
that we have twice as much in current assets as we need to satisfy obligations due in the near
future.
Importance:
You can use them to examine the current performance of your company in comparison to past
periods of time, from the prior quarter to years ago. Frequently, this can help you identify
problems that need fixing. Even better, it can direct your attention to potential problems that can
be avoided.
In addition, you can use these ratios to compare the performance of your company against that of
your competitors or other members of your industry.
Types of Financial Ratios

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 current ratio is a liquidity and efficiency ratio that measures a firm’s ability to pay off its
short-term liabilities with its current assets. The current ratio is an important measure of liquidity
because short-term liabilities are due within the next year.

A higher current ratio is always more favorable than a lower current ratio because it shows the
company can more easily make current debt payments.

 
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 quick ratio or acid test ratio is a liquidity ratio that measures the ability of a company to pay
its current liabilities when they come due with only quick assets. Quick assets are current assets
that can be converted to cash within 90 days or in the short-term. Cash, cash equivalents,
short-term investments or marketable securities, and current accounts receivable are considered
quick assets.
Higher quick ratios are more favorable for companies because it shows there are more quick assets
than current liabilities. A company with a quick ratio of 1 indicates that quick assets equal current
assets. This also shows that the company could pay off its current liabilities without selling any
long-term assets. An acid ratio of 2 shows that the company has twice as many quick assets than
current liabilities.

Efficiency Ratios/Activity
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 / Average total assets
 
The asset turnover ratio is an efficiency ratio that measures a company’s ability to generate sales
from its assets by compar-ng net sales with average total assets. In other words, this ratio shows
how efficiently a company can use its assets to generate sales.

The total asset turnover ratio calculates net sales as a percentage of assets to show how many
sales are generated from each dollar of company assets. For instance, a ratio of .5 means that
each dollar of assets generates 50 cents of sales.
The total asset turnover ratio is a general efficiency ratio that measures how efficiently a company
uses all of its assets. This gives investors and creditors an idea of how a company is managed and
uses its assets to produce products and sales.

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
 
Inventory turnover is a measure of how efficiently a company can control its merchandise, so it is
important to have a high turn. This shows the company does not overspend by buying too much
inventory and wastes resources by storing non-salable inventory. It also shows that the company
can effectively sell the inventory it buys.

This measurement also shows investors how liquid a company’s inventory is. Think about it.
Inventory is one of the biggest assets a retailer reports on its balance sheet

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

Since the receivables turnover ratio measures a business’ ability to efficiently collect its
receivables, it only makes sense that a higher ratio would be more favorable. Higher ratios mean
that companies are collecting their receivables more frequently throughout the year. For instance,
a ratio of 2 means that the company collected its average receivables twice during the year. In
other words, this company is collecting is money from customers every six months.

Higher efficiency is favorable from a cash flow standpoint as well. If a company can collect cash
from customers sooner, it will be able to use that cash to pay bills and other obligations sooner.

 
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

The days sales in inventory is a key component in a company’s inventory management. Inventory is
a expensive for a company to keep, maintain, and store. Companies also have to be worried about
protecting inventory from theft and obsolescence.

Management wants to make sure its inventory moves as fast as possible to minimize these costs
and to increase cash flows. Remember the longer the inventory sits on the shelves, the longer
the company’s cash can’t be used for other operations.

 
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 its cost of goods sold:
Gross margin ratio = Gross profit / Net sales
 
Gross margin ratio is a profitability ratio that measures how profitable a company can sell its
inventory. It only makes sense that higher ratios are more favorable. Higher ratios mean the
company is selling their inventory at a higher profit percentage.

The profit margin ratio compares the net income of a company to its net sales:
Profit margin ratio = Operating income / Net sales

The profit margin ratio directly measures what percentage of sales is made up of net income. In
other words, it measures how much profits are produced at a certain level of sales.

This ratio also indirectly measures how well a company manages its expenses relative to its net
sales. That is why companies strive to achieve higher ratios. They can do this by either generating
more revenues why keeping expenses constant or keep revenues constant and lower expenses.

 
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 assets ratio measures how effectively a company can turn earn a return on its
investment in assets. In other words, ROA shows how efficiently a company can covert the money
used to purchase assets into net income or profits.

Since all assets are either funded by equity or debt, some investors try to disregard the costs of
acquiring the assets in the return calculation by adding back interest expense in the formula.

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

Return on equity measures how efficiently a firm can use the money from shareholders to generate
profits and grow the company. Unlike other return on investment ratios, ROE is a profitability ratio
from the investor’s point of view—not the company. In other words, this ratio calculates how much
money is made based on the investors’ investment in the company, not the company’s investment
in assets or something else.

CAPITAL STRUCTURE 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 ratio is a solvency ratio that measures a firm’s total liabilities as a percentage of its total
assets. In a sense, the debt ratio shows a company’s ability to pay off its liabilities with its assets.
In other words, this shows 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 because a
company with lower ratio also has lower overall debt. Each industry has its own benchmarks for
debt, but .5 is reasonable ratio.
A debt ratio of .5 is often considered to be less risky. This means that the company has twice as
many assets as liabilities. Or said a different way, this company’s liabilities are only 50 percent of
its total assets. Essentially, only its creditors own half of the company’s assets and the
shareholders own the remainder of the assets.
A ratio of 1 means that total liabilities equals total assets. In other words, the company would have
to sell off all of its assets in order to pay off its liabilities. Obviously, this is a highly leverage firm.

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 debt to equity ratio is a financial, liquidity ratio that compares a company’s total debt to total
equity. The debt to equity ratio shows the percentage of company financing that comes from
creditors and investors. A higher debt to equity ratio indicates that more creditor financing (bank
loans) is used than investor financing (shareholders).

A lower debt to equity ratio usually implies a more financially stable business. Companies with a
higher debt to equity ratio are considered more risky to creditors and investors than companies
with a lower ratio. Unlike equity financing, debt must be repaid to the lender. Since debt financing
also requires debt servicing or regular interest payments, debt can be a far more expensive form of
financing than equity financing. Companies leveraging large amounts of debt might not be able to
make the payments.

 
The interest coverage ratio shows how easily a company can pay its interest expenses:
Interest coverage ratio = Operating income / Interest expenses
 
Higher Interest Coverage Ratios indicate a healthier and less risky business to invest or loan to.

The debt service coverage ratio reveals how easily a company can pay its debt obligations:
Debt service coverage ratio = Operating income / Total debt service
 
The debt service coverage ratio measures a firm’s ability to maintain its current debt levels. This is
why a higher ratio is always more favorable than a lower ratio. A higher ratio indicates that there
is more income available to pay for debt servicing.

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 Earnings per share measures the amount of net income earned per share of stock outstanding:
Earnings per share = Net Income – Dividends / Weighted Average of Shares
Earning per share is the same as any profitability or market prospect ratio. Higher earnings per
share is always better than a lower ratio because this means the company is more profitable and
the company has more profits to distribute to its shareholders.

 
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
 
Investors use the dividend yield formula to compute the cash flow they are getting from their
investment in stocks. In other words, investors want to know how much dividends they are getting
for every dollar that the stock is worth.

A company with a high dividend yield pays its investors a large dividend compared to the fair
market value of the stock. This means the investors are getting highly compensated for their
investments compared with lower dividend yielding stocks.

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
Earning per share is the same as any profitability or market prospect ratio. Higher earnings per
share is always better than a lower ratio because this means the company is more profitable and
the company has more profits to distribute to its shareholders.

 
The price-earnings ratio compares a company’s share price to its earnings per share:
Price-earnings ratio = Share price / Earnings per share

The price to earnings ratio indicates the expected price of a share based on its earnings. As a
company’s earnings per share being to rise, so does their market value per share. A company with a
high P/E ratio usually indicated positive future performance and investors are willing to pay more
for this company’s shares.

PROS AND CONS of RATIO ANALYSIS

ADVANTAGES  DISADVANTAGES
Helpful in setting goals for high Large, multidivisional firms can only use it on a
performance divisional basis.
Useful for smaller firms with a narrow focus In times of high inflation, financial data is distorted
or divisions of large firms and not useful for ratio analysis.
Useful to analyze firm performance across Firms can cheat and window dress their financial
periods of time statements.
Useful to compare firms on a cross-sectional Not useful for seasonal or cyclical firms due to time
or industry analysis distortion

 Helpful in setting goals for high performance: Through financial ratio analysis, financial
and business managers can determine acceptable financial performance for the business
firm. The firm can see what is a realistic performance by viewing its own performance across
time and aspire to better performance by looking at the industry leader's financial data.
 Useful for small firms with a narrow focus or divisions of large firms: Large,
multidivisional firms don't find financial ratio analysis useful for the firm as a whole. Since
ratios are only useful when compared to industry or firm financial data, smaller firms with
one line of business or the divisions of larger firms find ratio analysis useful.
 Useful to analyze a firm performance across periods of time: Time-series or trend
financial ratio analysis lets firms evaluate financial performance across periods of time such
as a quarter or a fiscal year.
 Useful to compare firms on a cross-sectional or industry basis: Comparing a firm's financial
performance to a group of similar firms within an industry allows the financial manager to
see where the firm stands competitively.
 Not useful for large, multidivisional firms: Since ratio analysis is only useful on a
comparative basis, divisions of large firms can use this financial analysis technique, but it is
not useful for a multidivisional company as a whole.
 Problems if there is inflation: If the business firm is operating in an inflationary
environment, financial data will be distorted from one time period to another and ratio
analysis will not be useful
 Window dressing: Firms can cheat and window dress their financial statements. Window
dressing is the act of making financial statements look stronger but manipulating data.
 Seasonal and cyclical firms: If business firms have seasonal or cyclical sales, financial ratio
analysis using time-series data would yield distorted results since sales vary widely between
time periods.