Financial ratios are simply the numerical values that can be derived from companies’ financial statements to provide quantitative approach for both estimating company’s future performance and comparing the performance with other companies.
Usually, investors are the ones who are mostly interested in those values since their objective is to find the company which is most likely to provide the best performance with their money. So they might want to know which company can use its assets more efficiently.
Nevertheless, financial ratios can be also useful for company itself to detect patterns, trends that is emerged. By detecting, companies can foresee the risks or opportunities well.
We can categorize these ratios according to their purpose of usage as followed
Profitability Ratios, a way to assess company’s ability to generate profit relative to its revenue, operating costs, equity, balance sheet assets.
If you are an investor and you may want to ask that “How efficiently you are generating income and value?”
The company will probably respond you back with those profitability ratios
Profit Margins (gross margin, operating margin, pretax margin, net profit margin)
Gross Margin Ratio, Gross profitability = Gross Profit/Net Sales x100= (Net Sales-Cost of Goods Sold(COGS))/ Net Sales to show how much profit company makes after the cost of goods sold are paid.
Operating Margin Ratio= Operating Profit(EBIT) /Net Sales x100 to show the contribution of operations towards the profitability.
Pretax Profit Margin = Profit Before Taxes / Net Sales x 100 to show operating efficiency before taxes, generally used to compare companies in same sector since tax expenditures might be misleading.
Net Profit Margin Ratio= Net Profit /Net Sales x100 to show the ability to generate profit after all expenses an taxes
NOTE! In Income Statement Revenue refers to net sales or you can find net sales as gross sales- sales return.
Return on Assets Ratio (ROA) = Net Profit/ Total Assets X 100 to show how effectively the assets of the company are being used to generate income. This ratio increases when returns grow faster than assets. With the increase in effectively managed assets, the costs decrease but margins increase with the effect of economies of scale, resulting higher rate in net profit than total assets. So high ROA can be a sign of efficient management, but be careful because ROA can be effected by unusual expenses so low ROA not necessarily means inefficient management.
Return on Equity (ROE)= Net Profit/ Average Shareholders’ Equity X 100 to show company’s ability to gain profit on its equity investments
Return on Investment= Net Profit/ Cost of Investment x100 of Investment to show how much you received for every dolar,euro etc. you spent
Earnings per share: Net Income/Number of Shares Outstanding to state company’s profits per-share
Liquidity Ratios
Liquidity ratios are being used to indicate how successful company is in terms of paying its current obligations. This means that liquidity ratios are the way of showing available cash and other assets to cover liabilities.
When we consider available amount of cash, we should say that generally start-ups and young companies do not have high levels of liquidity so low liquidity ratios should not be overestimated while low liquidity in a well-established companies may be a sign of inefficient management.
Current Ratio= Current Assets/Current Liabilities to indicate whether company is able to pay its obligations in short term (within 1 year)
Quick Ratio (Acid-test ratio) = Quick Assets/Current Liabilities = Current Assets- Inventories/Current Liabilities to again indicate company’s ability to pay its short-term liabilities but with quick assets
Cash ratio = Cash and Cash equivalents / Current Liabilities to measure a company’s ability to pay off short-term liabilities with cash and cash equivalents
Leverage Ratios
Leverage ratios, one of the measures of risks, indicate company’s dependence upon borrowing to finance its operations. This means mostly investors and bankers are the ones who are mostly interested in leverage ratios. Increase in leverage ratio may be a sign of high risk, but this should not be perceived as negative because it may provide higher returns also.
Debt to Equity Ratio= Debt/Owners’ Equity = Total Liabilities/ Shareholder’s Equity weighs the total debt and financial liabilities against shareholders’ equity to show the company’s financial leverage. Moreover, D/E can be considered as a Gearing Ratio, which is a financial ratio comparing owner’s equity to debt or funds borrowed.
Debt Ratio (Debt-to-Assets Ratio)= Total liabilities/Total Assets = Debt/Total Assets to show the portion of the capital provided by borrowing
The inverse of this formula (current) represents Working Capital which measures company’s ability to pay its debt with its current assets, Working Capital= Current Assets/Current Liabilities
Interest coverage= Operating Profit/Interest expenses= EBIT/Interest expenses to indicate company’s ability to pay its interest expenses.
Efficiency Ratios
These ratios are used to indicate company’s ability to use its liabilities and assets to generate sales.
Asset turnover ratio = Net sales / Total assets reflects the ability to generate sales from assets
Inventory turnover ratio = Cost of goods sold / Average inventory to measure the times when company’s inventories are sold
Annual inventory turnover: Cost of Goods Sold for the Year/Average Inventory
Receivables turnover ratio = Net credit sales / Average accounts receivable measures the ability to turn credit sales into cash.
Inventory to assets ratio Inventory/Total Assets to reflect the portion of assets tied up in inventory.
Inventory holding period (Days sales in inventory ratio): 365 days/Annual Inventory Turnover = 365 days / Inventory turnover ratio to show average number of days spend in inventory before sales
Market Value Ratios
Market value ratios are used to asses the current share price of company’s stock. Generally, investors are interested in those ratios to decide whether the company is underpriced or over-priced.
Price-earnings ratio (P/E) = Share price / Earnings per share used to understand whether the shares are over-riced or underpriced after comparing with competitors
Earnings per share ratio = Net earnings / Total shares outstanding generally used by investors to understand the price they think the shares worth.
Market value per share. = The total Market Value / total number of shares outstanding. To indicate the value that the market currently assigns to each share of a company's stock.
Book value per share ratio = Shareholder’s equity / Total shares outstanding to calculate the per-share value of a company based on equity available to shareholders
Dividend yield ratio = Dividend per share / Share price to reveal how much a company pays out in dividends each year relative to its stock price
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