Financial Ratio and Its Types

Do you want to know what financial ratio is and what are its different types? You are on the right place to the answer of this query.

Financial ratio that is also known as accounting ratio is related magnitude of two selected ratios taken from the company financial statement. We may also says that financial ratio analyze the financial functionalities of the company.

Different Types of Financial Ratios

Now let’s check below the types of financial ratios. There are five different types of financial ratios which are probably analyzed during this whole process of financial ratios functionality.

See Also: What is Financial Management

1. Liquidity & Solvency Ratios

Liquidity ratio show the ability of company paying debts and balance in between the company cash reserved and the payments. There are two types of liquidity ratio: current ratio and quick test ratio.

1 – Current Ratio: The ratio between current assets & liabilities is known as current ratio. It reflects that how many current assets do the company owns for every dollar in current liabilities.

The better it is considered as generally higher the ratio. Less productive use of current assets may be implied by too high ratio. An ideal ratio is considered as (2:1).

Current Ratio = Current Assets / Current Liabilities

2 – Quick/Acid Test Ratio: A relatively tight measure of liquidity is quick ratio. By subtracting inventory from current assets and dividing the consequence from current liabilities, quick ratio is get. Depending on the nature of the business, a desirable quick ratio can range from (0.8:1) to (1.5:1).

Acid/Quick Test Ratio = (Current Assets – Inventory) / Current Liabilities

Average Collection Period: In how many days the Accounts receivables of a company are changed over into cash are reflected in average collection period. Average collection period is calculated by using the following formula

Average Collection Period = Accounts Receivables / (Annual Sales / 360)

2. Profitability Ratios

The profitability ratios reflects the unite effects of asset management, liquidity and debt management on operating result.

1 – Profit Margin (On Sales): Profit margin on sales is one of the most commonly used sales. For every dollar of revenue earned, percentage of profit is showed in this ratio.

Profit Margin (On Sales) = (Net Income / Sales) X 100

2 – Return on Assets: Another profitability ratio is return on assets in which profitability of the company against each dollar invested in total assets is shown. By dividing the net profit with total assets, this ratio is simply obtained.

Return on Assets = (Net Income / Total Assets) X 100

3 – Return on Equity: Since equity represents the owner’s share in the business, return on equity is special interest to shareholders.

By dividing net income with the total equity, return on equity can be got. How much profit is generated by the company for each dollar in equity, showed by this ratio.

Return on Equity = (Net Income / Common Equity)

3. Asset Management Ratios

How effectively the business organization is managing its assets, is measured by these asset management ratios.

1 – Inventory Turnover: Within one accounting cycle, inventory turnover reflects the number of times the inventories are replenished. By dividing the sales by inventory, this ratio can be obtained.

Inventory Turnover = Sales / Inventories

2 – Total Assets Turnover: Greater revenue to the business organization is ensured by an effective use of total assets held by company.

The total assets turnover ratios are computed in order to measure how effectively a business organization has employed its total assets to make revenues. By dividing sales by total assets, this ratio is obtained.

Total Assets Turnover = Sales / Total Assets

4. Debt (Or Capital Structure) Ratios

The measurement leverage amount used by company in terms of total debts to total assets knows as company debt ratio. There are two types of debts ratios: debts assets and debt equity.

1 – Debt-Assets: Debt to asset ratio is the commonly used ratio to measure the capital structure of the business organization. Financing mix of a business organization refers to as capital structure.

Less willing would be the investors & creditors to give more financing to the business organization when there is greater amount of debt in the financing mix. Greater than 0.66 to 1 ratio is viewed as alarming for the givers of funds.

Debt-Asset = Total Debt / Total Asset

2 – Debt-Equity: The proportion of debt to equity is explicitly shown by another commonly used ratio known as debt to equity. For new projects, a ratio of 60 to 40 is used.

Debt-Equity = Total Debt / Total Equity

Times-Interest-Earned

The ability of a business organization to pay its financial charges (interest) is reflected in times-interest-earned. By dividing the operating profit by the interest charges, this ratio is obtained.

Times-Interest-Earned = EBIT / Interest Charges

5. Market Value Ratios

The stock price of a business organization is related to its earnings & book value per share in market value ratios. These ratios provide signals of what equity investors think of the business organization’s past performance & future prospects.

1 – Price Earnings Ratio: The price earnings ratio reflects that how many investors are ready to pay per rupee of reported income. The lack or optimism thereof the investors have about the future performance of the business organization is shown in this ratio.

Price Earnings Ratio = Market Price per Share / Earnings per Share

2 – Market/Book Ratio: An indication about how the equity investors regard the business organization’s value is provided by market to book ratio. This ratio is also employed in case of acquisition, mergers or even bankruptcy.

3 – Earnings per Share (EPS): It has the following formula

Earnings per Share (EPS) = Net Income / Average Number of Common Shares Outstanding