Without first understanding how your firm compares to the competition, it can be challenging to take action to assist in expanding your business. Examine your company’s financial ratios if you want to judge the state of your business and find areas where it can be improved. These may serve as helpful indicators of how well your firm is doing financially in many areas.
Every firm, whether a newborn startup or an already established brand, needs to analyze its Financial position and performance to constantly keep track of its growth. These ratios assist in finding out the position of the firm concerning various parameters like Price per Equity, Assets and Liabilities of the company, Interest payable on debts, Return on investment and many more.
What are Financial Ratios?
Financial ratios are calculated using data from your business’s financial statements. Your profit and loss (P&L) statement, balance sheet, and cash flow statement all fall under this category.
The quantitative analysis technique is used to evaluate a company’s liquidity, leverage, growth, margins, profitability, rates of Return, valuation, and other factors using the data on its financial statements. You should gather the necessary documentation before calculating your business’s financial ratios.
Let us understand Ratio Analysis by a simple example mentioned below:
Investors use the net profit margin, often known as the bottom line or the Profit margin, to assess the profitability of businesses operating in the same industry. An investor can use this ratio in place of analyzing financial documents to analyze how lucrative different companies are.
Assume, for instance, that companies ABC and DEF operate in the same industry and have profit margins of 50% and 10%, respectively. Investors can simply compare the two businesses and conclude that while DEF converted 10% of its revenues into profits, ABC converted 50% of its revenues into earnings.
Assuming the businesses in the scenario above have P/E ratios of 100 for ABC and 10 for DEF. The average investor concludes that investors are prepared to pay $100 for every $1 in earnings generated by ABC but only $10 for every $1 in earnings generated by DEF.
“We are surrounded by data but starved for insights.”
Jay Baer
What are the Uses of Financial Ratios?
Knowing a financial ratio is not sufficient; you must also learn how to use it in a firm to your advantage. Whittington (1980) identified two principal uses for financial ratios for corporations. The conservative use of a firm’s ratio measurement compared to the industry standard and the positive use of estimating empirical relationships are beneficial for predictive purposes.
A corporation benefits in two ways from calculating financial ratios:
Track the performance
A corporation can track its value over time with financial ratios. It aids in identifying the patterns that are emerging within an organization. Using the debt-to-asset ratio as an example of a financial ratio, its significance can be better appreciated. A corporation with a high debt-to-asset ratio may be overextended and at risk of default in the future.
Facilitates comparative judgement
It is possible to determine whether a company or a corporation is performing better or worse than the overall industry average by comparing its financial ratios to those of its main competitors. An analyst or investor can easily identify which company utilizes its assets most effectively by comparing the Returns on assets among different companies.
Ratio analysis is crucial since it could provide a more accurate image of a company’s operational state. Think about a business with $1 billion in revenue from the previous quarter. Even though everything seems to be in order, the company might have seen lower earnings relative to equity than in previous periods, a fall in liquidity ratio indicators, and a negative gross profit margin. Static data may not adequately convey a company’s performance on its own.
Types of Financial Ratios
Financial ratios are mentioned four categories:
- Liquidity Ratios or Working Capital Ratio
- Leverage Ratios or Debt Ratios
- Efficiency Ratios or Activity Ratios
- Profitability Ratios
These financial ratios can be further divided into subparts depending on the item and the time period. Let us understand every ratio in detail.
Liquidity Ratio
Financial measurement liquidity ratios assess a company’s capacity to pay off both short-term and long-term debt. The following is the list of liquidity ratios which typically includes:
Current Ratio
The current ratio looks at how effectively your business can settle off its current liabilities with its current assets. Using your company’s financial balance sheet, you can easily determine the total value of your assets and liabilities. You are more likely to be able to meet your financial responsibilities shortly if your current ratio is greater.
Current ratio = Current assets / Current liabilities
Acid-Test Ratio
The quick ratio, also known as the acid test ratio or cash ratio, is an excellent predictor of your company’s short-term liquidity. It informs you of the maximum number of times liquid assets could be used to settle a debt. The fast ratio does not consider assets that are difficult to convert into cash, in contrast to the current ratio (such as inventory). Quick ratios between 1.5 and 2.0 are typically regarded as healthy.
Acid-test ratio = Current assets – Inventories / Current liabilities
Cash Ratio
The ability of a corporation to pay down obligations entirely using liquid assets is assessed using the cash ratio, a liquidity indicator (cash and cash equivalents such as marketable securities). Creditors use it to assess how readily a corporation can pay down short-term liabilities.
Cash ratio = Cash and Cash equivalents / Current Liabilities
Net Working Capital Ratio
It serves as a gauge for cash flow. This ratio should have a positive response. Typically, bankers monitor this ratio to determine whether a financial crisis is present.
Net working capital ratio = Current Assets – Current liabilities (exclude Short-term bank borrowing)
Debt Ratio
Debt ratios are used to calculate how much capital is derived from debt. In other words, debt ratios are employed to assess the quantity of debt held by an organization. The following are examples of common debt ratios:
Debt-to-asset Ratio
The debt-to-asset ratio illustrates how your company’s assets stack up against its total debt. As a larger debt-to-asset ratio suggests that a sizable amount of your total assets is made up of liabilities, such as commercial loans, it might indicate financial insecurity.
Debt-to-asset ratio = Total liabilities / Total assets
Debt-to-equity Ratio
Growth is a noble objective, but companies that take on a lot of high-interest loans to get there risk getting into trouble when it comes time to make payments. The debt-to-equity ratio will assist you in assessing your company’s debt capacity, in other words, if you can prudently take on more debt. When evaluating requests for company loans, lenders normally aim for a debt-to-equity ratio of two to one or below.
Debt to equity ratio = Total liabilities / Shareholder’s equity
Interest Coverage Ratio
The interest coverage ratio focuses mainly on the amount of interest you owe on your company’s outstanding debt. It is determined by dividing your earnings by the total amount of interest that must be paid within a specific time frame. The times interest earned ratio is another name for this kind of ratio.
Interest coverage ratio = Operating income / Interest expenses
Activity Ratios
Activity ratios are especially useful when comparing companies that are rivals in the same industry to determine how one business stacks up against its competitors. However, activity ratios can also be used to track changes in a company’s financial performance over several recording periods. These data points might be plotted to demonstrate a corporation’s prospective performance.
Asset Turnover Ratio
The asset turnover ratio is influenced by the company’s sales and net assets or capital employed. Utilizing the company’s net assets assesses the business’s capacity to create sales income.
Asset turnover ratio = Net sales / Capital Employed
Inventory Turnover Ratio
One of the most significant turnover ratios illustrates the connection between the business’s inventory or stock and the Cost of goods sold. The amount of times the stock is sold or consumed within an accounting period, or how quickly the inventory is cleared, is shown.
Inventory turnover ratio = Cost of goods sold / Average inventory
Receivables Turnover Ratio
This ratio is a crucial business indication because it demonstrates how well a company can offer credit to its clients while still being able to reclaim the amount owed within the payment period. Because payments for credit sales will be made in the future, it is also known as the debtor turnover ratio.
Receivables turnover ratio = Net credit sales / Average accounts receivable
Profitability Ratios
With operating expenses, taxes, and debt payments considered, a company’s potential to generate income is assessed using profitability measures. These ratios are quite important for business owners and possible investors looking into your company.
Gross Profit Ratio
A profitability ratio known as the gross profit ratio assesses the correlation between gross Profit and net sales revenue. It is also referred to as the Gross Profit Margin when expressed as a percentage.
Gross margin ratio = Gross profit / Net sales
Operating Margin Ratio
The operating margin ratio, also referred to as the Return on sales ratio, assesses the operating effectiveness of a business by contrasting operating income with net sales:
Operating margin ratio = Operating income / Net sales
Return on Investment
Return on investment (ROI), also known as Return on capital employed (ROCE), is a profitability statistic that assesses how effectively a business can produce profits from its capital. It is a significant ratio that investors frequently utilize to screen potential investment candidates.
ROI = EBIT ÷ Capital Employed × 100
Where EBIT = Earnings before interest and taxes or Profit before interest and taxes and Capital Employed = Total Assets – Current Liabilities
Return on Equity
A company’s ROE is a critical metric for shareholders because it indicates how well a business can provide a return on its equity capital. ROE, determined by dividing net income by shareholders’ equity, might increase in the absence of more equity investments. Increased net income from a larger asset base backed by debt may cause the ratio to rise.
Return on equity ratio = Net income / Shareholder’s equity
Price-Earning Ratio
This also goes by the name P/E Ratio. It establishes a link between a company’s stock price (share price) and earnings per share. Investors will be more interested in learning about the profitability of the company’s shares and how much more profitable it will be in the future, so this information is quite beneficial.
P/E Ratio = Market value per share ÷ Earnings per share
It reveals whether the stock of the company is overvalued or undervalued.
We at Coinxwire offers number one business blockchain and crypto news network on the planet.
Frequently Asked Questions(FAQs)
- What is the significance of Financial Ratio Analysis?
Ans: The organization must do a ratio analysis to determine its financial condition, liquidity, profitability, risk, solvency, efficiency, the efficacy of its operations, and the proper use of cash. Additionally, it shows a trend or comparison of financial outcomes useful for company shareholders making investment decisions.
- Who uses Financial Ratio Analysis?
Ans: Both internal and external partners to the organization use financial ratios:
- External users include financial analysts, small-scale investors, creditors, rivals, taxing and regulating bodies, and industry watchers.
- Internal users: The management group, personnel, and proprietors
- What is the difference between a liability and a debt?
Ans: Liability in accounting and bookkeeping refers to a company’s responsibility resulting from a previous transaction. On the other hand, some individuals refer to all the sums a business owes when they use the word “debt.” In other terms, they refer to all liabilities as debt.
