What is financial ratio analysis?
A financial ratio is a mathematical and quantitative analysis and expression to demonstrate a relationship between two independent or related accounting values.
These all are calculated on the basis of accounting information gathered from financial statements.
Types of Financial Ratios Analysis:
There are mostly 6 different types of accounting ratios to perform and analyse a financial statement such as: Liquidity Ratios, Solvency Ratios, Activity Ratios, Profitability Ratios, Cash Flow Indicator Ratios and Market Value Ratios.
Four different ways to show financial ratios are;
- Simple or Pure– A pure ratio is shown as a quotient. For example – 4:1
- Percentage– this kind of representation is completed in type of a percentage. For example 40%
- Turnover Rate or Times– Accounting ratio uttered in form of rate or times. For example 4 times.
- Fraction– It is when a ratio is articulated in a fraction. For example 4/3 or 1.33
Types of Accounting Ratios
Liquidity ratios are the ratios that assess the ability of a company to pay off its short term debt obligations when they fall due.
The liquidity ratios are a consequence of dividing cash and other short term assets by the short term borrowings and current liabilities. It helps with the evaluation of a company’s ability to satisfy its short-term commitments.
They give us an idea about the number of times the short-range debt obligations are covered by the cash and liquid assets. If the value is greater than one that means the short term obligations are fully covered and safe.
Generally, the higher liquidity ratios are indicative sign of the higher margin of safety that the company posses to pay off its current liabilities.
Simply we can say that greater than one liquid ratio is great sign of the company is in good financial health and it is less likely fall into financial crisis.
Most common examples of liquidity ratios include current ratio, acid test ratio (also known as quick ratio), cash ratio and working capital ratio, times interest earned ratio, absolute ratio.
All the assets are considered to be relevant to liquid assets that can be converted into cash immediate effect or may be converted into cash or liquid in short time to meet the short term liabilities in an emergency.
Some analysts consider the debtors and trade receivables as relevant assets additionally to cash and cash equivalents. The value of inventory too considered relevant asset for calculations of liquidity ratios by some analysts.
The concept of money cycle is so important for better understanding of liquidity ratios. The cash continuously cycles through the operations of an organization. A company’s cash is usually liked to the finished goods, the raw materials, and trade debtors.
It is not until the inventory is sold, sales invoices raised, and therefore the debtors’ make payments that the firm receives cash.
The cash engaged within the cash cycle is understood as working capital, and liquidity ratios attempt to measure the balance between current assets and current liabilities.
In short we can say liquidity ratios are used to measure the availability of cash to pay debt. Higher the liquidity ratios better the company’s cash position.
Main types of liquidity ratios are;
- Acid Test Ratio or Quick Ratio
- Cash Ratio
- Current Ratio
- Net-Working Capital
- Working Capital Ratio
- Super Quick Ratio or Absolute Liquid Ratio
- Defence Interval ratio
- Times Interest Earned Ratio
Debt Ratios, Solvency Ratios and Leverage Ratios
Financial leverage ratios (debt ratios) or Solvency Ratios
It is an ability to judge the long term debt paying capacity of the company. Means, it measures the ability of a company to meet its long term financial obligations when they fall due.
Financial leverage ratios debt ratios) indicate the ability of a company to repay principal amount of its debts, pay interest on its borrowings, and to meet its other financial obligations. They also give insights into the mix of equity and debt a company is using.
Financial leverage ratios usually compare the debts of an organization to its assets. The common examples of financial leverage ratios include debt ratio, interest coverage ratio, capitalization ratio, debt-to-equity ratio etc.
Financial leverage ratios indicate the short-term and long-term solvency of an organization. These sources can be in the form of debt or equity. Debt is the creditor interest in the company. Equity is that the ownership interest within the company.
It also indicates about the financial health of a company. These ratios give indications whether an organization has enough financial resources to coat its financial obligations when the creditors and lenders seek their payments.
A company’s leverage is the relative amount of the fixed cost of the capital, main debts in the capital structure of the company. Leverage creates financial risk which is directly connected to the cost of the company. These ratios can give warnings to the shareholders and directors of potential financial difficulties.
Indicate whether the financial position of a company is improving or deteriorating over time. Industry analysis will indicate how well an organization is performing as compared to other companies within the same industry.
Companies need to carefully manage their financial leverage ratios to keep their financial risk at acceptable level. Careful management of financial leverage ratios is also important when seeking loans from banks and financial institutions.
Main types of solvency ratios are;
- Asset Coverage Ratio
- Capitalization Ratio
- Debt Ratio
- Debt Service Coverage Ratio (DSCR)
- Debt to Equity Ratio
- Debt to Income Ratio
- Debt to EBITDA Ratio
- Equity Multiplier
- Equity Ratio
- Financial Leverage Ratio
- Fixed Asset to Net Worth
- Fixed Charge Coverage Ratio
- Interest Coverage Ratio
- Long Term Debt to Capitalization Ratio
- Long term to Total Asset Ratio
- Non Current Asset to Net Worth
- Total Expense Ratio
Asset management (turnover) ratios or Activity Ratio
Activity Ratio is the ratio by which we compare the assets of a company to its sales revenue. Asset management ratios indicate how successfully, efficiently, and effectively a company is utilizing its assets to generate its revenues.
It is also known as performance ratios, turnover ratios, and efficiency ratios. These ratios also act as tunnel of transforming its assets into the sales.
Asset management ratios are computed for different assets. Common examples of asset turnover ratios include fixed asset turnover, inventory turnover, accounts receivable turnover ratio, and cash conversion cycle.
These ratios provide important insights into different financial areas of the firm and its highlights its strengths and weaknesses.
High asset turnover ratios are enviable because they indicate that the company is utilizing its assets efficiently to produce sales. The higher the asset turnover ratios, the more sales the corporate is generating from its assets.
Different industries have different requirements with reference to assets. It would be imprudent to compare an e-commerce store which requires small assets where as a manufacturing organization which requires huge manufacturing facilities, plant and machinery.
Every company has to maintain its level of these ratios to operate wisely to update and regulate its reputation in the market and take care its profit penetration.
The relation between profit margin and asset turnover inversely to each other because It has often been observed that companies with high profit margins have lower asset turnover ratios.
In simple term , companies with lower profit margins tend to possesses higher asset turnover ratios.
Asset turnover ratios are not always very useful. Asset turnover ratios would not give useful insights into the asset management of companies which sell highly profitable products but hardly.
Higher turnover ratio means better utilization of assets which indicates improved efficiency and profitability.
Main types of activity ratios are;
- Asset Turnover Ratio
- Inventory or Stock Turnover Ratio
- Receivable or Debtor’s Turnover Ratio
- Fixed Asset Turnover Ratio
- Trade Payables or Creditor’s Turnover Ratio or Accounts Payable Turnover Ratio
- Capacity Utilization Ratio
- Working Capital Turnover Ratio
- Cash Conversion Cycle ( Operating Cycle)
- Days Inventory Outstanding (DIO)
- Days Payable Outstanding ( DPO)
- Days Sales Outstanding (DSO)
- Defensive Interval Ratio (DIR)
Profitability ratios: As name implies shows earning capacity of the company with respect to the resources employed. These are the measurement a company’s ability to generate earnings relative to sales, assets and equity.
These ratios consider the ability of a company to generate income, profits and cash flows relative to some amount of money invested. These indicate that how effectively the profitability of a company is being managed.
Profitability is the ultimate goal of a company for overall success of a business. Simple examples of profitability ratios include return on sales, return on investment, return on equity, return on capital employed (ROCE), gross profit margin and net profit margin etc.
All of these ratios indicate how well a company is performing to generate profits or revenues relative to a certain situation.
Different profitability ratios present different useful consequence into the financial health and performance of a company.
For example, gross profit and net profit ratios tell us how well the company is managing its expenses. Return on capital employed (ROCE) tells how well the firm is using capital employed to come up with returns. Return on investment tells whether the corporate is generating enough profits for its shareholders.
A higher value of these ratios is desirable. A higher value means that the company is doing well and it is better to generate profits, revenues and cash flows.
Profitability ratios are in isolation gives little value. They give meaningful information only when they are analyzed in comparison to competitors or compared to the ratios in previous periods.
Therefore, analysis and industry analysis is required to draw meaningful conclusions about the profitability of an organization.
These are totally varying company to company and nature of the business. They also depend on the season and experience of the business operations.
Main types of profitability ratios are;
- Gross Profit Ratio
- Operating Profit Ratio
- Operating Expense Ratio
- Net Profit Ratio
- Net Interest Margin
- Cash Return on Capital Invested (CROCI)
- Price Earnings Ratio or Earning Retention Ratio
- DuPont Formula
- Earnings Before taxes (EBT)
- Earnings Before Interest and Taxes (EBIT)
- Earnings Before Interest After Taxes (EBIAT)
- Earnings before interest, tax, depreciation and amortization (EBITDA)
- Earnings Before Interest, Taxes, Depreciation, Amortisation, Rent, and Management Fees (EBITDARM)
- Net operating profit less adjusted taxes (NOPLAT)
- Operating income before depreciation and amortization(OIBDA)
- Effective Rate of Return (ERR)
- Over Head Ratio
- Profit Analysis
- Profitability Index
- Relative Return
- Return on Asset (ROA)
- Return on Average Asset (ROAA)
- Return on Average Capital Employed (ROACE)
- Return on Equity (ROE)
- Return on Average Equity (ROAE)
- Cash Return on Investment or Return on Capital Employed (ROCE)
- Return on Debts (ROD)
- Return on Invested Capital (ROIC)
- Return on Investment (ROI)
- Return on Net Asset (RONA)
- Return on Revenue (ROR)
- Return on Retained Earnings (RORE)
- Return on Research Capital (RORC)
- Return on Sales (ROS)
- Risk Adjusted Return (RAR)
- Revenue Per Employee (RPE)
Cash Flow Indicator Ratios
Cash flow per While net income is subject to management judgment and discretion in choice of accounting policies and preparation of accounting estimates, the net cash flows from operating activities is more actual figure, and potentially more reliable.
Cash flow describes a revenue or expense flow that changes a cash account over a given period of time. Cash inflows usually arise from one of three activities like financing, operations or investing, although this also occurs as a result of donations or gifts in the case of personal finance. Cash outflows outcomes from expenses or investments.
It is a financial ratio that measures the operating cash flows attributable to each share of common stock. It is a variation of the incomes per share which substitutes net income with net cash flows from operations. This holds right for both business enterprise and personal finance.
In accounting statement known the “statement of cash flows”, which shows the amount of cash generated and used by a company in a given period.
While net income is subject to management judgment and discretion in choice of accounting policies and preparation of accounting estimates, the net cash flows from operating activities is more concrete figure, and potentially more reliable.
It indicates the company’s financial strength.
- Cash Flow Coverage Ratio
- Cash Flow Management
- Free Cash Flow/Operating Cash Flow Ratio
- Operating Cash Flow/ Sales Ratio
- Price/ Cash Flow Ratio
Market value ratios
Market value ratios are evaluate the current share price of a publicly-held company’s stock on the basis of past activity of a company and present market value to presume the future outlook.
These ratios are very important, because, current and potential investors to determine whether a company’s shares are over-priced or under-priced.
The growth in prices of shares increases investment. The most common market value ratios are as business valuation, Dividend Payout, Yield, LTV stock price etc.
Market value ratios are not applied to the shares of privately-held entities, since there is no accurate way to assign a market value to their shares.
The most common market value ratios are
- Dividend Yield
- Dividend Payout Ratio
- Dividend Policy Ratio
- Business Valuation
- Enterprise Value
- Enterprise Value Multiple
- EV/EBITDA Ratio
- Loan to Value Ratio
- PEG Ratio
- Gordan Growth Model
- Net Asset Value Per Share (NAVPS)
- Price to Earnings Ratio (P/E Ratio)
- Price to Research Ratio
- Price / Book Value Ratio
- Price / Sales Ratio
- Stock Price