Updated July 24, 2023
Definition of Financial Ratio
Financial ratios are the ratio between various measures given on the financial statements such as sales, net income, total assets and liabilities, and so on, which are calculated periodically to analyze the performance of a company among its peers or over time and understand what it can do better to improve its performance.
In this article, we see all the information on the List of Financial Ratios. There are various aspects that the company, management, investors, and the board of directors need to look at for investment or management purposes. These ratios help determine what decisions need to be taken strategically or from an investment point of view. These ratios also help point out what is an area of improvement and how the company is performing compared to its competitors and itself over time.
Types of Financial Ratios
There is a list of Financial Ratios:
1. Profitability Ratios
Profit arises when revenues and incomes are greater than the costs and expenses; therefore, these ratios suggest how well the company manages its expenses and how much profit it generates from the given level of revenue. Various ratios fall under this umbrella:
- Gross Profit Margin = Gross Profit / Net Sales
- Operating Margin = Operating Income / Net Sales
- Net Profit Margin = Net Profit / Net Sales
- Return on Equity = Net Profit / Shareholder’s Equity
The shareholder’s equity can be an end-of-the-year figure or an average figure, as per the need of the analysis.
- Return on Assets = Net Profit / Total Assets
The total assets can be an end-of-the-year figure or an average figure, as per the need of the analysis.
2. Liquidity Ratios
The company’s liquidity ratios measure the amount of available liquidity, such as the number of assets it can quickly convert to cash or hold in cash and cash equivalents. Various ratios fall under this umbrella:
- Current Ratio = Current Assets / Current Liabilities
- Quick Ratio (Acid test ratio) = (Current Assets – Inventories) / Current Liabilities
- Cash Ratio = Cash and Cash Equivalents / Current Liabilities
3. Activity or Efficiency Ratios
These define how efficiently the company uses its assets and other revenue-generating resources.
- Asset Turnover Ratio = Net Sales / Total Assets
- Receivables Turnover Ratio =Net Credit Sales / Net Receivables.
The denominator can be an end-of-the-year figure or an average figure
- Average Collection Period = Accounts Receivable / Credit Sales x 365
365 days can be adjusted to 360 or any other number as per requirement and convention
- Degree of Operating Leverage = % of Net Operating Income / % Change in Sales
- Days of Sales Outstanding Ratio = Accounts Receivable / Total Annual Sales x 365
- Average Payment Period = Accounts Payable / Credit Purchases x 365
Conversion Period
- Inventory Conversion Period = (Inventory / COGS) x 365
- Receivables Conversion Period = (Receivable / Net Sales) x 365
- Payments Conversion Period = (Payables / Purchases) x 365
- Cash Conversion Ratio = a +b – c
4. Solvency Ratios
These measures how much debt can be recovered from the resources available to the company. If a company has lesser resources, then it can be declared insolvent.
- Debt Ratio = Total Liability / Total Assets
- Debt to Equity Ratio = Total Debt / Total equity
- Times Interest Earned Ratio = EBIT / Interest Expense
- Debt Service Coverage Ratio = Net Operating Income / Total Debt Service Ratio
5. Market Ratios
- EPS = Net Income / Total Number of Shares
- Payout Ratio = Dividends / Net Income
- Retention Ratio = 1 – Payout Ratio
- P/E Ratio = Price / Net Income
- Dividend Yield = Dividends / Price
Importance of Financial Ratios
The importance of these ratios can be categorized as follows: internal users, such as the management or the board of directors, find them important, while external users, such as shareholders unaware of the day-to-day operations and prospective investors, also consider them important.
Ratios, such as activity ratios, are more important to internal users, while ratios, such as market ratios, are more important to investors and staggered shareholders. Other ratios, such as solvency and profitability, are equally important to internal and external users.
Ratios mostly help in comparative analysis in the peer group or time series analysis or even in the trend analysis to improve where it is lacking, and investors can decide whether it is worth investing in a given company.
Advantages and Disadvantages of Financial Ratios
Below are the advantages and disadvantages of Financial Ratios:
Advantages of Financial Ratios
- Points out Areas of Improvement: Suppose a company has a lower asset turnover ratio than its competitors. It is aware that it either needs to reduce assets or increase sales. This can be done by increasing expenses on business development activities or by utilizing idle capacity so the company can formulate the strategies going forward
- Planning: Suppose a company’s debt ratio is increasing over time; it gets a hint that it needs to reduce the debt or take up other funding routes because the assets are insufficient to pay off the debtor won’t be in times to come. Therefore ratios act as a check on excessive spending or debt accumulation.
- Defines Limits: Every organization or industry defines the ideal level of certain ratios. This helps the companies verify whether the company ratios fall within the defined limits and keep a close check on unwanted or risky endeavors.
- Popular: Ratios are a popular analysis tool and are calculated regularly internally and externally by almost all companies.
Disadvantages of Financial Ratios
- Calculation Differences: Every publisher calculates the ratios in a different manner and breaks down the information given in the financial statements and notes to the financial statements. At times they include certain numbers and exclude others. Therefore there is lower uniformity in the numbers published by different publishers. This makes comparison very difficult.
- Subjected to Accounting Practices: Accounting practices can manipulate certain ratios which are not measured using cash flows; for example, using a written down value method for depreciation will inflate the value of the asset and thus show a better solvency position of the company as compared to the true and fair position.
Conclusion
Finally, we can say that the ratios help internal and external users of the financial statements to draw conclusions regarding the company’s financial position. Still, it may not be easy to calculate them at times due to variations in their definition and methodology.
However, these facilitate comparing the company’s performance to its own and its competitors. Therefore, it is a good measure of common sizing of all kinds of companies within a sector and analyses what strategic or investment decisions should be made.
Recommended Articles
This is a guide to a List of Financial Ratios. Here we discuss a list of Financial Ratios with Formulas and Advantages and Disadvantages. You may also look at the following articles to learn more –
