After striving for months to generate revenue as a company, how do you ascertain your financial performance? Or when you want to invest in a company, how do you know whether it is a profitable buy or not? Most importantly, how do you analyze where your firm stands financially in the competitive market?
We got you thinking? Worry not! Financial Ratio and Financial Analysis are the two popular ways that help you crack answers to many such business-critical questions.
In this article, you will not only learn about financial ratio analysis but also what it means for your company. But before we get to the crux, let us understand what a financial ratio is.
What is Financial Ratio?
Companies big scale or small, financial health is crucial to all, so guess what leads the way to become aware of your financial status? Financial ratios.
Financial ratios, aka Accounting ratios, are the values extracted from a company's financial statements- balance sheet, income statement, cash flow statement, and statement of changes in owner's equity. But what do you do once you have these numerical values? Here is when financial ratio analysis comes to play.
The financial ratio alone does not make a very useful story, however once studied and analyzed, it tells you everything you must know about your company. So, let's take a closer look at financial ratio analysis.
What is Financial Ratio Analysis?
Financial Ratio Analysis is evaluating and interpreting the financial statement provided by the company. It takes every numerical value in the financial datasheets, market research, and economic developments into consideration to determine two important aspects of running a business:
- Performance of your Company: Financial ratios help spot any drifts in the monetary values of a company over time if and when compared to past financial records of the company.
- Performance of your company V/s the competitor: Being aware of your competitor's financial performance is another vital aspect of running a business. By making a direct comparison with your competitors, you understand your position in the market. Moreover, this also reveals ways in which you can stay afloat in the industry.
There are different types of financial ratios and their formulas used in financial ratio analysis. Let's try to understand what distinct purposes do these ratios fill.
Types of Financial Ratios
Liquidity Ratios
Liquidity ratios measure the ability of a company to pay back long-term as well as short-term debt obligations.
Following are the three main liquidity ratios:
1. Current Ratio: Measures the ability of a company to return short-term liabilities with current assets. A list of liability and current assets is found easily in your balance sheet, so you can calculate the current ratio using the formula given below.
Formula for Current Ratio = Current assets / Current liabilities
2. Acid-test Ratio: Measures the ability of a company to repay short-term liabilities with quick assets. Liquid assets such as cash, accounts receivables, and marketable securities are mainly considered for the acid-test ratio. This leaves out current assets like inventory and prepaid expenses because they are less liquid.
Formula for Acid-test ratio= Current assets - Inventories / Current liabilities
3. Cash Ratio: Measures the ability of a company to pay off short-term liabilities with cash or cash equivalents. The cash ratio takes the most liquid assets, cash, and marketable securities of the company into consideration.
Formula for Cash Ratio= Cash and cash equivalents / Current liabilities
4. Cash Flow Ratio: Measures the number of times a company can pay off current liabilities with the cash generated in a given time.
Formula for Cash flow ratio= Cash flow / Current liabilities
Leverage Financial Ratios
Leverage ratios measure the amount of capital that comes in the form of debt. It indicates whether the operations of a company, financed using debts or equity. Debt ratio and debt to equity ratio are two ratios one must keep in mind while calculating leverage financial proportions.
1. Debt Ratio: Measures the relative amount of a company's assets supported from debt.
Formula for Debt Ratio= Total liabilities / Total assets
2. Debt to Equity Ratio: Measures the amount of total debt and financial liabilities opposed to shareholder's proprietorship.
Formula for Debt to Equity Ratio= Total liabilities / Equity
3. Interest Coverage Ratio: Reflects how easily a company can pay off its interest values.
Formula for Interest Coverage Ratio= Operating income/ Total debt service
4. Debt Coverage Ratio: Reflects how easily a company can pay off its debts.
Formula for Debt Coverage Ratio= Income / Total Debt
Efficiency Ratios
Efficiency ratios measure the utilization of resources and assets by a company. Efficiency ratios are of four types:
1.Asset Turnover Ratio: Measures a company's ability to generate sales from the available assets.
Formula for Asset Turnover Ratio= Net sales / Average total assets
2. Inventory Turnover Ratio: Calculates the number of times a company's inventory is sold and replaced over a period.
Formula for Inventory Turnover Ratio= Cost of goods sold/ Average inventory
3. Accounts Receivable Turnover Ratio: Calculates the number of times a company can convert receivables into cash in a given time.
Formula for Receivables Turnover Ratio= Net credit sales / Average accounts receivable
4. Days Sales in Inventory Ratio: Calculates the number of days a company holds on to inventory before selling it to customers.
Formula for No. of Days Sales in Inventory Ratio= 365 days/ Inventory turnover ratio
Profitability Ratios
Profitability ratios help measure a company's ability to generate income in relation to revenue. Gross margin ratio, operating margin ratio, return on assets ratio, and return on equity ratio are the four common profitability ratios commonly used.
1. Gross Margin Ratio: Makes a comparison between the gross profit of a company to its sales. This, as a result, reflects upon profit made by a company after paying the cost of goods sold.
Formula for Gross Margin Ratio= Gross profit/ Net sales
2. The Operating Margin Ratio: A comparison is made between the operating income of a company to its net sales. This, as a result, helps to ascertain the operating efficiency of a company.
Formula for Operating Margin Ratio= Operating income / Net sales
3. Return on Assets Ratio: Measures how efficiently a company uses its assets to generate profit.
Formula for Return on Assets Ratio= Net income / Total assets
4. Return on Equity Ratio: Measures how efficiently a company uses its equity to generate profit.
Formula for Return on Equity= Net income/ Shareholder’s equity
Market Value Ratios
Market value ratios Calculate the share price of a company's stock. These ratios are mostly calculated for publicly held firms and rarely used for very small businesses. The three primary market value ratios are:
1. Price / Earnings Ratio (P/E): Reflects the amount investors are willing to pay for the stock of the business firm per dollar of profits.
Formula for Price-earnings = Share price / Earnings per share
2. Price / Cash flow Ratio: The value of the firm is based on its free cash flows. A price/cash flow ratio judges how well the business generates cash flow.
Formula for Price- Cashflow= Stock price / Cash flow per share
3. Market/book ratio: This ratio provides another financial indicator of how investors view the value of the company.
Formula for Market/book ratio= shareholder's equity - preferred equity / Total common shares outstanding
Over to You
These are the financial ratios that should be in your company's toolkit to walk ahead of its time in the market!
You don't have to be a math wiz or a financial guru to calculate and track the important financial ratios. Getting an online accounting and finance software helps you with that.
Deskera with its built-in analytics allows you to keep track of your business health and calculate financial ratios with ease.
We hope this article helped you get insights into financial ratio analysis, types of financial ratios, and how Deskera can make your life easy.