Financial Ratio Analysis

Definition: Financial ratio analysis can be explained as a better understanding of the company’s position by correlating multiple elements of its financial statements at a time. These ratios provide an insight to the investors, clients, stakeholders and government authorities. Also, it is an essential tool for business decision making by the directors or the stakeholders.

In other terms, we can say that financial ratio analysis is a mirror that reflects the corporate strengths, weaknesses and potential in front of the world.

Financial Ratio Analysis

Financial Ratios

The financial ratios establish a resourceful relationship between the numerical figures of a company’s financial statements such as income statement, balance sheet and the cash flow statement.

Types of Financial Ratios

The list of financial ratios is limitless since, with ages, new ratios are added to simplify the task of the investors, financial institutions, board of directors and other corporate associates.

Let us find out the six different categories of financial ratios below:

Types of Financial Ratios

Liquidity Ratios

The company’s potential of meeting its current obligations i.e., the short-term liabilities from the available cash or other liquid assets is determined through the liquidity ratios. A company proficient in managing its short-term needs, always secure higher liquidity ratios.

There are different kinds of liquidity ratios as state below:

Cash Ratio: This metric determines the ability of the firm to clear its current liabilities from the cash and marketable securities it possesses. The current liabilities include short-term debts, accounts payable, dividends payable, notes payable, interest outstanding and other short-term obligations. The formula is:

Cash Ratio

Current Ratio: The current ratio measures the company’s short-term capabilities i.e., it’s potential to meet the current obligations from the available current assets. The current assets comprise cash, inventory, accounts receivables, marketable securities, cash equivalents and other liquid assets. The formula is:

Current Ratio

Net Working Capital Ratio: The company’s working capital efficiency can be analyzed through this metric. It figures out the difference between the current assets and the current liabilities to know whether there is a surplus or deficit of the former. The formula is:

Net Working Capital

Quick or Acid Test Ratio: Another important liquidity ratio is the quick ratio which determines the company’s capability of immediately settling its current liabilities by using the quick assets, i.e., cash, accounts receivables and marketable securities. The formula is:

Acid Test Ratio

Profitability Ratios

The organization’s efficiency to generate returns from the business can be identified through its profitability ratios. The six prominent types of profitability ratios are as follows:

Gross Profit Margin: This is a measure that determines the gross margin of a company over its net sales, therefore a higher ratio is always a plus. The formula is:

Gross Profit Margin

Here, gross profit and net sales are computed as follows:

Gross Profit Formula
Net Sales Formula

Net Profit Margin: The net profitability of any firm determines its ability to generate returns after paying off the operating costs along with the indirect expenses. A high ratio signifies the strong profitability of the organization. The formula is:

Net Profit Margin

Here, net profit is calculated with the help of following formula:

Net Profit Formula

Operating Profit Margin: This metric features the organizational efficiency of yielding profits after incurring the operating expenses of the business. Higher the ratio, better is the operating position of the company. The formula is:

Operating Profit Margin

While the operating income/profit is evaluated as:

Operating Income Formula

Return on Assets: The return on assets ratio outlays the company’s expertise in putting its assets into use. If this ratio is high, it demonstrates the organizational competency of profit generation from the assets employed. The formula is:

Return on Assets

Return on Capital Employed: The prominent one of all is the return on capital employed ratio since it determines the income yielding capability of the firm by investing the available capital in the business. The formula is:

Return on Capital Employed

Return on Equity: This ratio demonstrates the organization’s potential of making a profit by engaging the shareholders’ fund in the business. Greater the ratio, better is the company’s performance. The formula is:

Return on Equity

The capital employed is determined as follows:

Capital Employed Formula

Leverage or Solvency Ratios

The extent of the organization’s financial dependency over the lenders such as a bank, other financial institutions and investors can be judged through the solvency ratios. The multiple leverage ratios used by the business are given below:

Debt Ratio: This ratio analyzes the company’s capacity to repay the debts through its total assets. A ratio lower than 1.0 is always considered to be favourable. The formula is:

Debt Ratio

Equity or Proprietary Ratio: The equity ratio picturizes the capitalization of a company, where the allocation of shareholders’ fund to the total assets of a firm is determined. The formula is:

Equity Ratio

Debt to Equity Ratio: The company’s borrowed funds and owners’ capital are compared to understand the financial risk involved. Lower the ratio more is the organization’s financial stability. The formula is:

Debt to Equity Ratio

Fixed to Worth Ratio: This ratio figures out the proportion of owners’ equity contributed to the net fixed assets of the firm. The net fixed assets comprise the tangible assets at its post depreciation price. The formula is:

Fixed to Worth Ratio

Efficiency Ratios

These ratios define the management’s ability to actively managing the credit sales, credit purchases and inventory over a certain period. The different types of efficiency ratios are explained below:

Receivables Turnover Ratio: The company’s ability to collect outstanding bills on the earliest possible dates can be determined through the receivables turnover period. It determines the number of times the company encashes its credit sales in a particular financial year. The formula is:

Receivables Turnover Ratio

Days Sales Outstanding: The average collection period specifies the number of days taken by the company at an average to recover its outstanding payments of the credit sales in a particular financial year. The formula is:

Days Sales Outstanding

Payables Turnover Ratio: A company is considered to have more working capital when the payables turnover ratio is low. This is because this metric determines the number of times the organization clears its debts of credit purchase in a given financial year. The formula is:

Payables Turnover Ratio

Days Payable Outstanding: Again the number of days taken by the organization at an average to pay off its debtors in a certain financial year is considered as its days payable outstanding or average payment period. The formula is:

Days Payable Outstanding

Inventory Turnover Ratio: This ratio estimates the frequency of converting the stocks into sales in a particular financial period. In simple words, the time take to consume the inventory for generating sales is estimated in inventory turnover ratio. The formula is:

Inventory Turnover Ratio

Days Inventory Outstanding: The frequency of converting the stock into sales for a particular financial year can be calculated with the help of days inventory outstanding. A low days inventory outstanding is considered to be favourable for the company. The formula is:

Days Inventory Outstanding

Total Asset Turnover Ratio: It is a crucial ratio tool which analyzes the efficient use of a company’s assets to generates sales. Higher the ratio, better it is. The formula is:

Total Asset Turnover Ratio

Fixed Asset Turnover Ratio: This is a parameter which identifies the efficient utilization of the company’s fixed assets for sales maximization by the management. A higher ratio shows a positive result. The formula is:

Fixed Asset Turnover Ratio

Working Capital Turnover Ratio: The management’s efficiency in increasing corporate revenue by using limited working capital can be analyzed through the working capital turnover ratio. The formula is:

Working Capital Turnover Ratio

Cash Turnover Ratio: The cash turnover ratio specifies the amount of cash and cash equivalents put in to generate sales in a particular accounting year. The formula is:

Cash Turnover Ratio

Operating Cycle: This parameter measures the overall time taken by the company to procure goods, making sales and receiving the due payments. A shorter cycle is always impressive since it represents a strong managerial ability. The formula is:

Operating Cycle

Cash Conversion Cycle: The number of days taken by the organization to generate money from the invested cash can be determined through the cash conversion cycle. The formula is:

Cash Conversion Cycle

Coverage Ratios

The risk involved in issuing the loan to a company can be determined with the help of its coverage ratios. Banks, investors and other financial institutions evaluate these figures before lending to a company. Following are the various forms of coverage ratios:

Times Interest Earned or Interest Coverage Ratio: The organization’s efficiency in meeting the due interest on the debts or borrowed funds from its earnings or profit is analyzed through the times’ interest earned. The formula is:

Interest Coverage Ratio

Asset Coverage Ratio: This ratio identifies the ability of the company to fulfil its debt liabilities through its asset liquidation. This ratio determines the corporate strength at the time of solvency. The formula is:

Asset Coverage Ratio

Debt Service Coverage Ratio: With the help of this parameter the company states its efficiency in paying off its prevailing debt liabilities through its operating income. The formula is:

Debt Service Coverage Ratio

EBITDA to Interest Coverage Ratio: The EBITDA to interest coverage ratio determines the company’s strength in settling its debt liabilities. A higher ratio signifies that the company is efficiently managing its liabilities. The formula is:

EBITDA to Interest Coverage Ratio

Fixed Charge Coverage Ratio: The organization’s ability to pay off its fixed expenses from the earnings it makes during a particular accounting year. The financial institutions judge an organization over this parameter before offering a loan. The formula is:

Fixed Charge Coverage Ratio

Preferred Dividend Coverage Ratio: This is a ratio to find out the company’s proficiency in fulfilling the preferred dividend payout through its net income. The formula is:

Preferred Dividend Coverage Ratio

Cash Coverage Ratio: The company’s efficiency in meeting the interest liabilities from the total cash it owns. It is always preferable to maintain a high debt coverage ratio. The formula is:

Cash Coverage Ratio

Market Value Ratios

The financial institutions, management, investors and associates use the market value ratios as an essential tool to understand the relation between stock valuation and yields of a publicly-traded company. The related metrics are explained below:

Book Value Per Share: The company’s stock undervaluation can be identified by evaluating the book value of each share through this method. This figure is then compared to the market value of these stocks to find any discrepancy. The formula is:

Book Value Per Share

Market Value Per Share: This metric specify whether it is fruitful to invest in a certain company’s stock or not. The market value per share is the price at which the stock is presently being traded in the open market. The formula is:

Market Value Per Share

Dividend Yield Ratio: A healthy company pays out a fair dividend to the shareholders. Therefore this method compares the dividend payout with the market value per share of a company. The formula is:

Dividend Yield Ratio

Market/Book Ratio: The market capitalization of a company is related to its book value under this method. It focuses on the companies having more tangible assets, such as financial institutions, insurance companies, investment trusts and real estate firms. The formula is:

Market Book Value

Earnings Per Share: EPS states the net profit earned by the company for each outstanding share. Therefore, earnings per share is an indicator of the company’s future performance and investment prospectives. The formula is:

Earnings Per Share

Price to Earnings Ratio: This is a mere index of the amount an investor needs to put in stocks for earning one dollar at average. It denotes the stock valuation in the market. The formula is:

Price to Earnings Ratio

Price to Book Ratio: For the companies holding more tangible assets, price to book value essentially denotes the relation between the market price and book value of the stock. The formula is:

Price to Book Ratio

Price to Sales Ratio: The company’s stock valuation in terms of its revenue can be analyzed with the help of price to sales ratio. A lower ratio indicates a favourable investment opportunity. The formula is:

Price to Sales Ratio

Conclusion

Financial ratio analysis can be seen as a quantitative approach to determine the corporate position in terms of liquidity, profitability, leverage, efficiency, coverage and market value. It is a widely used phenomenon around the world.

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