Get to Know the Fundamentals of Financial Ratios
Introduction
Financial ratios are a vital tool used by investors and financial professionals to understand the financial stability of a company or project. They provide an objective means for comparing different companies or capital investment opportunities. By understanding how to calculate, use, and interpret financial ratios, investors and finance professionals have access to a powerful metric that can be used to make better decisions.
Financial ratios can be classified in three broad categories: liquidity, profitability, and solvency. The ratios in each category capture different aspects of a company's financial performance and can be used to gauge the future potential of a company or project. In this article, we will look at how understanding financial ratios and their application can help you make better decisions.
Profitability Ratios
Financial ratios allow you to compare a company's performance over time and track and compare it to other companies in the same industry. Profitability ratios measure the performance of a business in terms of its profitability. With these ratios, you can evaluate the profitability of a business and make more informed decisions about your investments.
Gross Profit Margin
The gross profit margin is a ratio that measures the percentage of sales that remain after subtracting the cost of goods sold. It is calculated by dividing gross profit by total sales, and it measures a company's ability to generate a profit from sales. This ratio is often used as an indicator of a company's overall efficiency and ability to control costs.
Net Profit Margin
The net profit margin is a ratio that measures the bottom line performance of a business. It is calculated by dividing net profit by total sales and shows the percentage of each dollar of sales that the business has kept after paying all expenses. This ratio can be used to compare the profitability of different companies and help assess their overall financial health.
Return on Assets
Return on assets is a ratio that measures the efficiency of a company's management in generating profits from its assets. It is calculated by dividing net income by total assets and can be used to compare the profitability of different companies. This ratio is often used to assess the overall financial health of a business, as it indicates how well they are using their assets to generate profits.
Activity Ratios
Activity ratios measure a firm’s ability to manage its assets, which can help reveal how efficient and profitable a business can be. An understanding of activity ratios is important in order to make informed decisions while managing a business or investing in stocks.
Inventory Turnover
Inventory turnover measures how efficiently a company is managing its inventory. It’s calculated by dividing the cost of goods sold over a specific period of time (typically a year) by the average inventory for the same period. The higher the number, the more efficient the company is managing its inventory. This is important for investors to keep an eye on, since an efficient inventory can help a company save money and maximize its profit.
Franchise Receivable Turnover
Franchise receivable turnover measures how effectively a company is collecting its accounts receivable. It’s calculated by dividing net credit sales by average accounts receivable. The higher the number, the faster the company is able to collect its accounts receivables and the better it is able to manage its cash flow.
Asset Turnover
Asset turnover measures how efficiently a company is using its assets. It’s calculated by dividing sales or revenues over a period of time by the average of assets for the same period. The higher the number, the more efficient a company is using its assets and the better it is able to generate returns for investors. A high asset turnover also means that a company is able to generate more cash flow for other activities.
Liquidity Ratios
Liquidity ratios measure a company's ability to pay short-term debt obligations and meet unexpected cash needs.
Current Ratio
The current ratio is a liquidity ratio traditionally used to give an idea of a company's ability to pay back its short-term liabilities (debts and other payable) with its short-term assets (cash, inventory, receivables). It is calculated by dividing the company's current assets by its current liabilities.
Quick Ratio
The quick ratio is a more conservative test of a company's ability to pay off its liabilities in the event of an emergency. It is calculated by dividing the total of quick assets (cash, cash equivalents, and marketable securities and accounts receivable) by the total of current liabilities.
Cash Ratio
The cash ratio is the most conservative of the liquidity ratios; it measures the ability of a company to pay its current liabilities with just the cash and cash equivalent it holds. It is calculated by dividing the total cash and cash equivalents by the total of current liabilities.
Leverage Ratios
The term ‘leverage ratio’ is used to describe the relationship between a company’s total liabilities and its total assets. Leverage ratios measure a firm’s ability to pay off its debt and meet financial obligations. Understanding leverage ratios is important for investors, business owners and financial advisors, as they are used to assess a company’s financial stability. The following three leverage ratios are commonly used to evaluate a company's debt load.
Debt to Assets Ratio
The debt to assets ratio, also known as the debt ratio, is calculated by dividing the total amount of a company’s debt by its total assets. A high debt to assets ratio indicates that the company has a high level of debt relative to its assets. This means that the company may be exposed to more risk, as it has a larger portion of debt compared to its assets.
Interest Coverage Ratio
The interest coverage ratio is a measure of a company’s ability to pay its accrued interest expenses. It is calculated by dividing the company’s net income before interest and taxes (EBIT) by its total interest expenses. A higher interest coverage ratio indicates that the company is better able to meet its financial obligations.
Debt to Equity Ratio
The debt to equity ratio is used to compare a company’s total liabilities to its total shareholders’ equity. It is calculated by dividing the company’s total debt by its total shareholders’ equity. A high debt to equity ratio indicates that the company has a higher level of debt relative to its equity, which means that its debt burden is relatively high. On the other hand, a low debt to equity ratio indicates that the company has a lower level of debt relative to its equity, which means that its debt burden is relatively low.
Market Value Ratios
Market value ratios, also known as valuation ratios, are used to compare the current price of a company against its intrinsic value. These ratios help investors and financial professionals determine the true value of a company’s stock, and can be a useful tool in making buying and selling decisions. Three of the most commonly used market value ratios are the Price to Earnings Ratio (P/E), Price to Book Value Ratio (P/BV), and Price to Sales Ratio (P/S).
Price to Earnings Ratio (P/E)
The Price to Earnings Ratio (P/E) compares the market price of a company’s stock to its earnings per share (EPS). It is calculated by dividing the stock’s market price per share by the EPS. Investors typically use the P/E ratio to gauge whether a stock is under or overvalued. A high P/E ratio usually indicates that investors are expecting an increase in earnings in the future. On the other hand, a low P/E ratio could mean that the company’s earnings are not growing at a satisfactory rate or are expected to decline in the future.
Price to Book Value Ratio (P/BV)
The Price to Book Value Ratio (P/BV) compares the market price of a company’s stock to its book value per share. This ratio is calculated by dividing the stock’s market price per share by the book value per share. The book value is a measure of a company’s intrinsic value and includes tangible assets, such as cash and property, as well as intangible assets, like goodwill and patents. A high P/BV ratio generally indicates that the company’s stock is overvalued, while a low P/BV ratio suggests it is undervalued.
Price to Sales Ratio (P/S)
The Price to Sales Ratio (P/S) measures a stock’s market price divided by its sales per share. It is calculated by dividing the stock’s market price per share by its revenue per share. Investors use the P/S ratio to gauge a company’s financial performance and make sound investing decisions. A high P/S ratio can indicate that the stock is overvalued and a low P/S ratio could mean the stock is undervalued.
Conclusion
Financial ratios allow you to effectively analyze the financial performance and health of a company. With the right understanding, you can use these ratios to consider the costs and returns associated with any business decision, ultimately leading to improved financial outcomes. By understanding and using financial ratios wisely, you're in a better position to make smart business decisions.
Summary
In this blog post, we discussed financial ratios and how they can help you make better decisions. We covered the different types of financial ratios — those related to profitability, liquidity, solvency, efficiency, capital structure and investments. We also discussed the various ways financial ratios can be used, such as analyzing the financial performance of a company or to compare the company's performance against similar companies. Finally, we discussed how leveraging financial ratios can lead to improved financial outcomes.
Advantages of Understanding Financial Ratios
- Financial ratios can provide insights into a company’s performance.
- Financial ratios can help analyze the potential profitability and health of a company.
- Financial ratios can support a company’s decision-making process.
- Financial ratios enable easy comparison of a company’s performance to that of competitors.
- Financial ratios are useful to creditors and investors when evaluating a company.
- Financial ratios can provide a snapshot of a company’s performance over time.