Financial ratio, also known as an accounting ratio, is the relative magnitude of two selected values taken from a company’s financial statements. We may also say that financial ratios analyze the financial functionalities of a company.
Different Types of Financial Ratios
Now let’s check the types of financial ratios. There are five different types of financial ratios which are commonly analyzed during the process of financial ratio analysis.
See Also: What is Financial Management
Liquidity & Solvency Ratios
Liquidity ratios show the ability of a company to pay its debts and maintain a balance between the company’s cash reserves and payments. There are two types of liquidity ratios: current ratio and quick test ratio.
1 – Current Ratio
The ratio between current assets & liabilities is known as the current ratio. It reflects how many current assets the company owns for every dollar in current liabilities.
Generally, a higher ratio is considered better. However, a very high ratio may imply less productive use of current assets. An ideal ratio is considered as (2:1).
Current Ratio = Current Assets / Current Liabilities
2 – Quick/Acid Test Ratio
A relatively stricter measure of liquidity is the quick ratio. By subtracting inventory from current assets and dividing the result by current liabilities, the quick ratio is obtained. 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
The average collection period reflects how many days the accounts receivables of a company take to be converted into cash. It is calculated using the following formula:
Average Collection Period = Accounts Receivables / (Annual Sales / 360)
Profitability Ratios
Profitability ratios reflect the combined effects of asset management, liquidity, and debt management on operating results.
1 – Profit Margin (On Sales)
Profit margin on sales is one of the most commonly used ratios. It shows the percentage of profit for every dollar of revenue earned.
Profit Margin (On Sales) = (Net Income / Sales) × 100
2 – Return on Assets
Return on assets shows the profitability of the company against each dollar invested in total assets. It is obtained by dividing net income by total assets.
Return on Assets = (Net Income / Total Assets) × 100
3 – Return on Equity
Since equity represents the owner’s share in the business, return on equity is of special interest to shareholders.
By dividing net income by total equity, return on equity is obtained. It shows how much profit is generated by the company for each dollar of equity.
Return on Equity = Net Income / Common Equity
Asset Management Ratios
These ratios measure how effectively the business organization is managing its assets.
1 – Inventory Turnover
Inventory turnover reflects the number of times inventory is replenished within one accounting cycle. This ratio is obtained by dividing sales by inventory.
Inventory Turnover = Sales / Inventories
2 – Total Assets Turnover
Effective use of total assets ensures greater revenue for the business organization.
This ratio measures how efficiently a company uses its total assets to generate revenue. It is calculated by dividing sales by total assets.
Total Assets Turnover = Sales / Total Assets
Debt (or Capital Structure) Ratios
The amount of leverage used by a company in terms of total debt to total assets is measured by debt ratios. There are two types of debt ratios: debt-assets and debt-equity.
1 – Debt-Assets Ratio
Debt to asset ratio is a commonly used ratio to measure the capital structure of a business organization. Capital structure refers to the financing mix of a business organization.
Investors & creditors are less willing to provide financing when there is a higher proportion of debt in the financing mix. A ratio greater than 0.66:1 is considered alarming for lenders.
Debt-Asset = Total Debt / Total Assets
2 – Debt-Equity Ratio
The proportion of debt to equity is shown by the debt-equity ratio. For new projects, a ratio of 60:40 is often used.
Debt-Equity = Total Debt / Total Equity
Times-Interest-Earned
This ratio reflects the ability of a business organization to pay its financial charges (interest). It is obtained by dividing operating profit by interest charges.
Times-Interest-Earned = EBIT / Interest Charges
Market Value Ratios
Market value ratios relate a company’s stock price to its earnings & book value per share. These ratios provide signals about what equity investors think of the company’s past performance & future prospects.
1 – Price Earnings Ratio
The price earnings ratio shows how much investors are willing to pay per rupee of reported income. It reflects investor expectations about the future performance of the company.
Price Earnings Ratio = Market Price per Share / Earnings per Share
2 – Market/Book Ratio
This ratio indicates how equity investors view the company’s value. It is also used in cases of acquisitions, mergers, or bankruptcy.
3 – Earnings per Share (EPS)
Earnings per share shows the portion of a company’s profit allocated to each outstanding share.
Earnings per Share (EPS) = Net Income / Average Number of Common Shares Outstanding
