Financial ratios indicate a company’s financial health.
They offer insights into how well a company can manage its debt, revenue, assets, and other financial instruments. Analyzing these financial ratios delivers information to make operations and strategic financial management decisions.
Dive deeper to learn more about different types of financial ratios, financial ratio formulas, and how professionals use them in their day-to-day operations. This article will walk you through steps to calculate financial ratios and ways you can interpret them.
What are financial ratios?
Financial ratios help understand a company’s financial health by comparing different aspects of financial data. They use data from the company’s balance sheet, such as income statements.
They view a company’s financial health from multiple angles. Some of them include:
- How well a company can pay its debts
- How efficient is resource utilization
- How good the company is making money
- Whether an organization can meet its long-term financial obligations
Suggested Reads: Financial Accounting
Types of financial ratios
You can refer to multiple types of financial ratios to make data-driven and informed business decisions. There are five important financial ratio types:
1. Liquidity ratios
2. Solvency ratios
3. Profitability ratios
4. Efficiency ratios
5. Market value ratios
Let’s dive into their details to understand with more clarity.
1. Liquidity ratios
Liquidity ratios measure a company’s ability to pay off its short-term debts. They show if a company has enough assets to cover its immediate liabilities. Three main types of liquidity ratios are the current ratio, quick ratio, and cash ratio. Each ratio offers a different insight into a company’s short-term financial health.
This ratio compares a company’s assets to its liabilities.
Current Ratio = Current Assets/ Current Liabilities
For example, if a company has ₹100,000 in current assets and ₹50,000 in current liabilities, its current ratio is 2. This means the company has twice as many assets as liabilities.
Also known as the acid-test ratio, it’s similar to the current ratio but more stringent. It excludes inventory from current assets.
Quick Ratio = Current Assets – Inventory/Current Liabilities
If your business has ₹100,000 in current assets, ₹30,000 in inventory, and ₹50,000 in current liabilities, its quick ratio is 1.4.
It indicates how well you can meet short-term obligations without selling inventory.
This is the most conservative liquidity ratio. It looks only at cash and cash equivalents compared to current liabilities.
Cash Ratio = Cash and Cash Equivalents/Current Liabilities
For instance, if you have ₹20,000 in cash and cash equivalents and ₹50,000 in current liabilities, your cash ratio is 0.4 ( ₹20,000 / ₹50,000). It tells us how much of your organization’s short-term liabilities can be paid using only cash and near-cash resources.
2. Solvency ratios
Solvency ratios measure a company’s ability to meet its long-term debts and obligations. They show if a company is financially healthy in the long run. A healthy solvency ratio indicates a stable company that can sustain operations and grow long-term. Here are a few key types of solvency ratios:
Debt to equity ratio
This ratio compares a company’s total liabilities to its shareholder equity. It shows how much the company finances its operations through debt versus its funds.
Debt to equity ratio = Total Liabilities / Total Shareholder’s Equity
If you have ₹2,00,000 in liabilities and ₹1,00,000 in shareholder equity, the debt-to-equity ratio is 2. It means your business has ₹2 of debt for every rupee of equity. But on its own, it doesn’t give any concrete information to investors.
Interest coverage ratio
This ratio tells us how well a company can pay the interest on its debt. It’s calculated by dividing the company’s earnings before interest and taxes (EBIT) by its interest expenses on its outstanding debts.
Interest Coverage Ratio = EBIT / Interest Expenses
Suppose a company’s EBIT is ₹50,000 and interest expenses are ₹10,000. The interest coverage ratio would be 5 ( ₹50,000 / ₹10,000), indicating the enterprises can easily cover their interest payments.
Debt service coverage ratio (DSCR)
DSCR measures the company’s ability to service its debt. It’s calculated by dividing the company’s net operating income by its total debt service. Debt service is the principal, interest, or lease payments due for the period.
DSCR = Net Operating Income /Total Debt Service
When your net operating income is ₹120,000, and a total debt service is ₹40,000, the DSCR is 3. It means the business earns three times more than it needs to cover its debt payments.
3. Profitability ratios
Profitability ratios show how well a company can generate profits from its operations. These ratios help investors and managers understand how effectively a company turns revenues into profits. They are crucial for comparing a company’s financial performance over time or against competitors.
Here are some common types of profitability ratios:
Gross profit margin
This ratio measures the percentage of revenue that exceeds the cost of goods sold (COGS). It shows how efficiently a company is producing its goods or services.
Gross Profit Margin = (Revenue – COGS/ Revenue) × 100
If an organization’s revenue is ₹200,000 and COGS is ₹150,000, its gross profit margin is 25%. This means 25% of the revenue is gross profit.
Net profit margin
This ratio shows the percentage of revenue that remains as profit after all expenses are deducted. It tells us how much profit a company makes for every sales rupee.
Net Profit Margin = (Net Income/ Revenue) × 100
With ₹200,000 in revenue and ₹30,000 as net income, the net profit margin is 15%. This means 15% of the revenue is your net profit. When you earn ₹1 as revenue, the net profit is ₹0.15.
Return on equity (ROE)
This ratio measures the company’s profitability relative to shareholder equity. It indicates how well the company uses investments to generate earnings growth. The formula is:
ROE = (Net Income/Shareholder’s Equity) × 100
Suppose you have a net income of ₹30,000 and the shareholders’ equity is ₹100,000; the ROE is 30%. This shows that you generate a 30% return on the equity.
Return on assets (ROA)
Return on assets shows how well a company uses its assets to profit. It compares your company’s net income to total assets.
ROA = (Net Income / Total Assets) × 100
For example, if your company has a net income of ₹50,000 and total assets of ₹2,00,000, ROA is 25%. It means the company generates a profit of ₹0.25 for every ₹1 of assets.
4. Efficiency Ratios
Efficiency ratios show how well a company uses its assets and liabilities to generate revenue and profits. They tell how effectively a business manages its operations. Here are some common types of efficiency ratios:
Inventory turnover ratio
This ratio shows how often a company sells and replaces its inventory over time. It helps understand how efficiently inventory is managed. The formula is:
Inventory Turnover Ratio = Cost of Goods Sold (COGS) / Average Inventory
When COGS is ₹150,000, and the average inventory is ₹30,000, the inventory turnover ratio is 5. It means the business sold and replaced its inventory five times.
Accounts receivable turnover ratio
This ratio indicates how many times a year a company collects its average accounts receivable. A higher number shows better collection practices.
Accounts Receivable Turnover Ratio = Net Credit Sales / Average Accounts Receivable
With net credit sales of ₹2,00,000 and average accounts receivable of ₹40,000, the ratio is 5. This means the company collects its receivables five times a year.
Asset turnover ratio
This ratio evaluates how efficiently a company uses its assets to generate sales. It shows the effectiveness of asset management.
Asset Turnover Ratio = Net Sales/ Average Total Assets
When net sales are ₹500,000 and average total assets are ₹250,000, the asset turnover ratio is 2. It states each rupee of assets generates ₹2 in sales.
5. Market value ratios
Market value ratios evaluate a company’s financial performance in the stock market. It helps you understand if a company’s stock valuation is accurate.
Price-earnings (P/E) ratio
This ratio compares a company’s current stock price to earnings per share (EPS). It shows what the market will pay for each rupee of earnings. You can calculate earnings per share by dividing the company’s net income by the total number of outstanding shares.
P/E Ratio = Current Share Price / Earnings Per Share (EPS)
If a company’s share price is ₹50 and its EPS is ₹5, the P/E ratio is 10. This means investors are willing to pay ₹10 for every ₹1 of earnings.
Price-to-book (P/B) ratio
This ratio compares the market value of a company’s shares to its book value. It shows how much investors are paying for the company’s net assets. You can calculate book value per share by dividing equity accessible to common shareholders by the total number of outstanding shares.
P/B Ratio = Current Share Price / Book Value Per Share
If the current share price is ₹50 and the book value per share is ₹25. It means the P/B ratio is 2. It indicates that the market value is twice the book value.
This ratio shows how much a company pays out in dividends relative to its share price. It measures your income for each rupee invested in the company’s stock.
Dividend Yield = (Annual Dividends Per Share / Current Share Price) × 100
Suppose an organization pays annual dividends of ₹2 per share and its share price is ₹40; the dividend yield is 5%. This means you get a 5% return in dividends on your investment.
How to calculate and interpret financial ratios
There are multiple steps involved when you calculate and interpret financial ratios. These steps are as follows:
- Gather financial statements. Collect your company’s financial statements, including balance sheets, income statements, and cash flow statements.
- Identify relevant data. Look for the specific numbers needed for each ratio. For example, you need current assets and liabilities from the balance sheet for the current ratio.
- Apply the formula. Leverage ratios formula mentioned above to calculate. For instance, to calculate the current ratio, divide current assets by current liabilities.
- Calculate. Perform the math to arrive at the ratio you’re looking for. If current assets are ₹100,000 and current liabilities are ₹50,000, the current ratio is 2.
After following these steps, you’ll have a final ratio needed. But these ratios as standalone instruments don’t make much sense. Comparing it with your organization’s historical data, or against industry average will supply the insights you’re seeking.
You need to look for trends over time. Are the ratios improving or declining? Always consider the business context. For example, a low current ratio in a rapidly growing company might not be a concern if they invest heavily in growth.
Look at these ratios together for informed decision-making related to investment or operations.
Quick Read: Financial System
Applications of financial ratios
Multiple industries on the market use financial ratios to determine their company’s performance and financial health over time.
Below are the financial ratios people care about in the retail business.
- Inventory turnover tells how fast products sell.
- Gross profit margins help understand pricing strategies and control costs.
- Current and quick ratios indicate if they can pay short-term debts.
On the manufacturing side, businesses care about efficiency ratios to understand how well their team uses factory resources. The debt-to-equity ratio helps leaders understand how much the company relies on debt to finance operations.
On the other hand, return on equity shows how effectively capital is used to generate profit.
On the tech side, startups and growth-focused companies use cash ratios to understand their liquidity. Investors take more interest in the P/E ratio to understand market expectations for growth and earnings.
Related Reads: Financial Planning Tools
Challenges and limitations of financial ratios
While financial ratios are helpful, they should be used cautiously and as part of a broader analysis. They provide a snapshot of a company’s finances at a specific time, and you compare them or forecast them to understand historical or future trends. However, these ratios vary a lot across different sectors.
Financial ratios that don’t complement industry benchmarks don’t always indicate a problem. These ratios should be a part of a broader financial analysis instead of standalone insights guiding your decisions.
Conclusion: Toward improving financial health
These ratios offer valuable insights into a company’s financial health and performance. With an understanding of your liquidity, profitability, and efficiency, you can strive to make conscious changes to improve in financial matters.
Learn more about how you can perform financial analysis in your organization.
Financial ratios – FAQs
Financial ratios are categorized into five main types, including liquidity ratios, profitability ratios, efficiency ratios, solvency ratios, and market value ratios.
Financial ratios are numerical comparisons derived from a company’s financial statements, like the balance sheet and income statement. They provide insights into various aspects of a company’s financial health and performance. These ratios simplify complex financial information, making it easier to analyze and compare. For instance, profitability ratios reveal how effectively a company generates profit, while liquidity ratios assess its ability to pay off short-term debts.
Financial ratios are useful because they simplify complex financial data, allowing for easy comparison and analysis. They help stakeholders assess a company’s financial health, efficiency, and performance.
Ratios are classified based on their financial analysis purpose. Liquidity ratios measure a company’s ability to pay short-term obligations. Solvency ratios assess long-term debt-paying ability. Profitability ratios evaluate the efficiency in generating profits. Efficiency ratios analyze how well a company uses its assets and liabilities.
Financial ratios are widely used by investors, analysts, creditors, and company management. Investors and analysts use them to evaluate investment opportunities, creditors to assess creditworthiness, and management to make strategic business decisions and monitor operational efficiency.
The importance of a financial ratio largely depends on the specific needs and context of the user. For instance, investors often focus on return on equity (ROE) and price-earnings (P/E) ratios to assess profitability and value. Creditors might prioritize liquidity ratios like the current and quick ratios to evaluate a company’s ability to pay short-term debts. On the other hand, management may emphasize efficiency ratios such as asset turnover to assess operational effectiveness.
Financial ratios play a crucial role in analyzing a company’s financial health. It simplifies complex data, simplifies competitive analysis, helps businesses identify trends, and provides insights to analyze liquidity, profitability, and efficiency.
Interpreting financial ratios in a company’s annual report involves several steps:
Identifying key ratios
Comparing with industry standards
Considering the economic context
Reading management discussion