The use of financial figures to gain significant information about a company Show Financial ratios are created with the use of numerical values taken from financial statements to gain meaningful information about a company. The numbers found on a company’s financial statements – balance sheet, income statement, and cash flow statement – are used to perform quantitative analysis and assess a company’s liquidity, leverage, growth, margins, profitability, rates of return, valuation, and more. Financial ratios are grouped into the following categories: - Liquidity ratios
- Leverage ratios
- Efficiency ratios
- Profitability ratios
- Market value ratios
## Uses and Users of Financial Ratio AnalysisAnalysis of financial ratios serves two main purposes: ## 1. Track company performanceDetermining individual financial ratios per period and tracking the change in their values over time is done to spot trends that may be developing in a company. For example, an increasing debt-to-asset ratio may indicate that a company is overburdened with debt and may eventually be facing default risk. ## 2. Make comparative judgments regarding company performanceComparing financial ratios with that of major competitors is done to identify whether a company is performing better or worse than the industry average. For example, comparing the return on assets between companies helps an analyst or investor to determine which company is making the most efficient use of its assets. Users of financial ratios include parties external and internal to the company: **External users:**Financial analysts, retail investors, creditors, competitors, tax authorities, regulatory authorities, and industry observers**Internal users:**Management team, employees, and owners
## Liquidity RatiosLiquidity ratios are financial ratios that measure a company’s ability to repay both short- and long-term obligations. Common liquidity ratios include the following: The current ratio measures a company’s ability to pay off short-term liabilities with current assets:
The acid-test ratio measures a company’s ability to pay off short-term liabilities with quick assets:
The cash ratio measures a company’s ability to pay off short-term liabilities with cash and cash equivalents:
The operating cash flow ratio is a measure of the number of times a company can pay off current liabilities with the cash generated in a given period:
## Leverage Financial RatiosLeverage ratios measure the amount of capital that comes from debt. In other words, leverage financial ratios are used to evaluate a company’s debt levels. Common leverage ratios include the following: The debt ratio measures the relative amount of a company’s assets that are provided from debt:
The debt to equity ratio calculates the weight of total debt and financial liabilities against shareholders’ equity:
The interest coverage ratio shows how easily a company can pay its interest expenses:
The debt service coverage ratio reveals how easily a company can pay its debt obligations:
## Efficiency RatiosEfficiency ratios, also known as activity financial ratios, are used to measure how well a company is utilizing its assets and resources. Common efficiency ratios include: The asset turnover ratio measures a company’s ability to generate sales from assets:
The inventory turnover ratio measures how many times a company’s inventory is sold and replaced over a given period:
The accounts receivable turnover ratio measures how many times a company can turn receivables into cash over a given period:
The days sales in inventory ratio measures the average number of days that a company holds on to inventory before selling it to customers:
## Profitability RatiosProfitability ratios measure a company’s ability to generate income relative to revenue, balance sheet assets, operating costs, and equity. Common profitability financial ratios include the following: The gross margin ratio compares the gross profit of a company to its net sales to show how much profit a company makes after paying its cost of goods sold:
The operating margin ratio compares the operating income of a company to its net sales to determine operating efficiency:
The return on assets ratio measures how efficiently a company is using its assets to generate profit:
The return on equity ratio measures how efficiently a company is using its equity to generate profit:
Learn more about the different profitability ratios in the following video: Market value ratios are used to evaluate the share price of a company’s stock. Common market value ratios include the following: The book value per share ratio calculates the per-share value of a company based on the equity available to shareholders:
The dividend yield ratio measures the amount of dividends attributed to shareholders relative to the market value per share:
The earnings per share ratio measures the amount of net income earned for each share outstanding:
The price-earnings ratio compares a company’s share price to its earnings per share:
## Related ReadingsThank you for reading CFI’s guide to financial ratios. To help you advance your career in the financial services industry, check out the following additional CFI resources:
Financial ratios are measurements of a business' financial performance. Ratios help an owner or other interested parties develop an understand the overall financial health of the company. Financial ratios are used by businesses and analysts to determine how a company is financed. Ratios are also used to determine profitability, liquidity, and solvency. Liquidity is the firm's ability to pay off short term debts, and solvency is the ability to pay off long term debts. Commonly used financial ratios can be divided into the following five categories. Liquidity ratios focus on a firm's ability to pay its short-term debt obligations. The information you need to calculate these ratios can be found on your balance sheet, which shows your assets, liabilities, and shareholder's equity. Common liquidity ratios are the current ratio, the quick ratio, and the cash ratio. The current ratio is an indicator of your company's ability to pay its short term liabilities (debts). The quick ratio (sometimes called the acid-test) is similar to the current ratio. The difference between the two is that in the quick ratio, inventory is subtracted from current assets. Since inventory is sold and restocked continuously, subtracting it from your assets results in a more precise visual than the current ratio. The cash ratio is different from both the quick and current ratios in that it only takes into account assets that are the easiest to convert into cash. These assets are cash and cash equivalents, such as marketable securities, money orders, or money in a checking account. The solvency ratio represents the ability of a company to pay it's long term obligations. This ratio compares your company's non-cash expenses and net income after taxes to your total liabilities (short term and long term). The financial leverage or debt ratios focus on a firm's ability to meet its long-term debt obligations. They use the firm's long-term liabilities on the balance sheet such as payable bonds, long-term loans, or pension funds. Common financial leverage ratios are the debt to equity ratio and the debt ratio. Debt to equity refers to the amount of money and retained earnings invested in the company. The debt ratio indicates how much debt the firm is using to purchase assets. In other words, it shows if the company uses debt or equity financing. Sometimes called asset efficiency ratios, turnover ratios measure how efficiently a business is using its assets. This ratio uses the information found on both the income statement and the balance sheet. The turnover ratios used most commonly are accounts receivable turnover, accounts payable turnover, and inventory turnover. Accounts receivable turnover indicate how effective your company is at collecting credit debt. Accounts payable turnover expresses your efficiency at paying your accounts, and inventory turnover is a measurement of the amount of time it takes to consume and restock your inventory. When used together, turnover ratios describe how well the business is being managed. They can indicate how fast the company's products are selling, how long customers take to pay, or how long capital is tied up in inventory. These are ratios that measure if a business' activities are profitable. Frequently used ratios are the net profit ratio and the contribution margin ratio. The contribution margin ratio indicates if your products or services are generating a profit after variable expenses. The net profit ratio expresses profits after taxes to net sales. This ratio illustrates the percentage of profits remaining after taxes and all costs have been accounted for. There are many market value ratios, but the most commonly used are price per earnings (P/E) and dividend yield. The P/E ratio is used by investors to determine if a share of a company's stock is over or underpriced. The dividend yield is an important ratio for investors as it illustrates the return on their investment. |