Understanding Financial Ratios and Their Uses
Introduction
Financial ratios are one of the most important tools used by investors, managers, and analysts to evaluate the financial performance of a company. These ratios are calculated from financial statement information, such as ratios of capital structure, liquidity, efficiency, and growth. By using financial ratios, the performance of a company can be appropriately measured, benchmarked, and tracked over time.
Different types of financial ratios are used to evaluate a company's performance, liquidity, leverage, and profitability. These ratios are categorized into seven categories: liquidity ratios, activity ratios, leverage ratios, profitability ratios, coverage ratios, market performance ratios, and solvency ratios. Let's have a look at each of these categories in more detail.
Leverage Ratios
A leverage ratio is a financial metric used to measure debt levels relative to financial resources. It is a type of financial ratio that is used to check and provide more detailed analysis into an organization's ability to pay its debt obligations and performance. Leverage ratios are used by organizations and creditors to measure a company's financial position and ability to repay debt.
Purpose & Definition
The purpose of leverage ratios is to measure a company’s financial structure and its ability to pay off outstanding debts. Leverage ratios are typically used by investors and analysts to assess the risk associated with a company, as a high level of debt relative to equity could signal an increased risk.
Types of Leverage Ratios
The following are some of the more common types of leverage ratios:
- Debt-to-Equity Ratio
- Debt Ratio
- Asset-to-Equity Ratio
- Interest Coverage Ratio
- Cash Flow to Debt Ratio
How to Calculate Leverage Ratios
Leverage ratios are relatively easy to calculate. To calculate a leverage ratio, all you need is a company's financial statements and basic math. For example, to find a company's debt-to-equity ratio, take its total liabilities divided by its total equity. To calculate the debt ratio, divide a company’s total liabilities by its total assets. Once calculated, these ratios can be compared to industry benchmarks or company averages in order to ascertain the company's overall level of debt.
Liquidity Ratios
Liquidity ratios are used to measure a company's ability to pay off its short-term obligations; they indicate a firm's ability to satisfy its near-term operating requirements. Liquidity ratios display the ratio of a company's short-term assets to short-term liabilities. This indicates how easily the company can cover its liquidity needs.
Purpose & definition
Liquidity ratios measure a company’s ability to meet its short-term debt obligations. Liquidity ratios help evaluate how financially healthy a company is and if the company is able to quickly and efficiently turn its assets into cash. Not meeting short-term debt obligations can lead to credit downgrades or, even worse, bankruptcy.
Types of liquidity ratios
There are several main types of liquidity ratios, including the current ratio, quick ratio, cash ratio, and the cash conversion cycle.
- Current ratio measures a company’s ability to pay its current liabilities when they come due.
- Quick ratio measures a company’s ability to take on new debts without selling off assets.
- Cash ratio measures a company’s ability to pay its current liabilities by using only cash and cash equivalents.
- Cash conversion cycle measures the amount of time it takes a company to convert inventory into cash.
How to calculate liquidity ratios
To calculate liquidity ratios, the company's total current assets must first be divided by its total current liabilities. The resulting number is the current ratio. The quick ratio is the same calculation, but it does not include Inventory or Prepayment Account in the denominator of the equation. The cash ratio is calculated by dividing total cash and cash equivalent amount by total current liabilities. The cash conversion cycle is calculated by adding accounts receivable days, inventory days, and accounts payable days and subtracting the result from 365 days.
Profitability Ratios
Profitability ratios are used to measure the business’s ability to generate income and profits. Such ratios include, but are not limited to, gross profit margin, return on assets (ROA), and return on equity (ROE). These figures provide investors with insight into the financial health and efficiency of a company.
Purpose & Definition
Profitability ratios are used to measure the business’s ability to generate income and profits from the operation. This allows owners, shareholders, and investors to compare different companies and make informed decisions about which ones to invest in or work with. Additionally, it provides an early warning sign for potential financial issues.
Types of Profitability Ratios
The following are some of the most commonly used profitability ratios:
- Gross profit margin: This is the ratio of gross profit over total revenue. A high gross profit margin reflects that a company has a healthy bottom line.
- Return on assets (ROA): This is the ratio of income to average assets. A high return on assets reflects that a company's operations are providing a healthy return for its investors.
- Return on equity (ROE): This is the ratio of net income to average shareholders' equity. A high return on equity indicates that the company is capable of providing a good return on investments.
How to Calculate Profitability Ratios
Profitability ratios can be calculated using different methods depending on the specific ratio needed. Generally, they involve some combination of net income, total revenue, total expenses, gross profit, and shareholder's equity. The most common way to calculate profitability ratios is to divide the relevant items on a company's income statement by the appropriate balance sheet information.
Activity Ratios
Activity Ratios are used to measure how efficiently a business is utilizing its resources. These measures compare different components of the balance sheet, such as inventory, accounts receivable and liabilities, to compute how quickly and effectively the company is managing its financials.
Purpose & Definition
Activity Ratios show the effectiveness of a company's operational activities, providing a better insight into its financial health than other ratios. It translates into key operational metrics such as sales volume, cost of goods sold and operating expenses. Activity Ratios are used to show the relationship between different financial components and can indicate whether the business is efficiently using its resources.
Types of Activity Ratios
Below are common types of Activity Ratios used to compare the performance and efficiency of a company:
- Inventory Turnover Ratio: This ratio helps measure the rate at which a company sells its inventory and is calculated by dividing cost of goods sold by average inventory.
- Average Collection Period: This ratio helps measure how fast the company’s customers are paying off their invoices and is calculated by dividing the accounts receivable balance by sales and multiplying the answer by the number of days in the period.
- Total Assets Turnover Ratio: This ratio shows the effectiveness of a company in utilizing its assets to generate sales and is calculated by dividing total sales by total assets.
- Fixed Assets Turnover Ratio: This ratio helps measure the ability of a company to generate sales from its long-term assets and is calculated by dividing net sales by fixed assets.
- Liabilities & Equity Turnover Ratio: This ratio shows how fast the company is able to pay off its liabilities and is calculated by dividing total current liabilities by total equity.
How to Calculate Activity Ratios
Activity Ratios can be calculated by dividing the value of one item by the value of another item. For example, the inventory turnover ratio can be calculated by dividing the cost of goods sold by the average inventory. Similarly, the liabilities & equity turnover ratio can be calculated by dividing the total current liabilities by the total equity.
Coverage Ratios
The purpose of coverage ratios is to assess a company’s ability to fulfill its financial obligations. Coverage ratios measure a company’s ability to meet the interest payments or debt obligations. This type of ratio provides an indication of a company’s financial health and allows lenders and other stakeholders to assess the company’s ability to pay its debts.
There are several different types of coverage ratios:
- Debt Coverage Ratio: This compares a company’s income to its debt payments. It is used to measure a company’s ability to make its monthly debt payments.
- Interest Coverage Ratio: This measures a company’s ability to make interest payments. It is calculated by dividing the income before interest and taxes by the interest expenses.
- Fixed Charge Coverage Ratio: This compares a company’s income to its other fixed costs such as rent, closing costs and insurance. It is calculated by dividing the income before interest, taxes and other fixed charges by the total amount of the other fixed charges.
It is important to note that coverage ratios are not always predictive. While they can provide a general indication of a company’s debt-servicing ability, they do not always reflect potential future risks. They can, however, be used as an additional tool to assess a company’s financial health.
How to Calculate Coverage Ratios
Coverage ratios can be calculated in several different ways. Generally, they are calculated by dividing the company’s income before interest and taxes by the total interest expenses or other fixed charges. For example, the Debt Coverage Ratio is calculated by dividing the income before interest and taxes by the total interest payments.
It is important to note that the calculation of coverage ratios may vary depending on the type of ratio being calculated. Therefore, it is important to ensure that the correct formula is used in order to accurately measure the company’s debt servicing ability.
Conclusion
Financial ratios are an important tool for analyzing the performance of a firm and assessing its financial health. These ratios provide a comparative look at a company's performance and position when compared to the industry or the past. There are numerous types of financial ratios that each have their own unique uses and are used to assess performance in different ways, such as by analyzing liquidity, profitability, efficiency, debt, and market position.
The most common types of ratios include liquidity ratios, profitability ratios, efficiency ratios, leverage ratios, and market value ratios. These ratios are used to ascertain the financial stability of a firm and help investors determine the overall health of a company. By understanding these different types of ratios and their uses, investors, creditors, and other interested parties will have a better insight into a firm's operations and be able to assess the risks associated with a potential investment.
It is important to understand financial ratios and what they measure in order to make sound investment decisions. Ratios can give you an idea of the firm's price to earnings ratio, debt to equity ratio, and guidance on whether to invest in the company or not. Ratios can give you an understanding of the firm's profitability and efficiency, provide an insight into a firm's liquidity, and indicate whether a company's stock is a value buy.