Financial ratios are created with the use of numerical values taken from financial statements to gain meaningful information about a company. The numbers found on a company’s financial statements – balance sheet, income statement, and cash flow statement – are used to perform quantitative analysis and assess a company’s liquidity, leverage, growth, margins, profitability, rates of return, valuation, and more.
Financial ratios are grouped into the following categories:
Liquidity ratios
Leverage ratios
Efficiency ratios
Profitability ratios
Market value ratios
Uses and Users of Financial Ratio Analysis
Analysis of financial ratios serves two main purposes:
1. Track company performance
Determining individual financial ratios per period and tracking the change in their values over time is done to spot trends that may be developing in a company. For example, an increasing debt-to-asset ratio may indicate that a company is overburdened with debt and may eventually be facing default risk.
2. Make comparative judgments regarding company performance
Comparing financial ratios with that of major competitors is done to identify whether a company is performing better or worse than the industry average. For example, comparing the return on assets between companies helps an analyst or investor to determine which company is making the most efficient use of its assets.
Users of financial ratios include parties external and internal to the company:
External users: Financial analysts, retail investors, creditors, competitors, tax authorities, regulatory authorities, and industry observers
Internal users: Management team, employees, and owners
Liquidity Ratios
Liquidity ratios are financial ratios that measure a company’s ability to repay both short- and long-term obligations. Common liquidity ratios include the following:
The current ratio measures a company’s ability to pay off short-term liabilities with current assets:
Current ratio = Current assets / Current liabilities
The acid-test ratio measures a company’s ability to pay off short-term liabilities with quick assets:
Acid-test ratio = Current assets – Inventories / Current liabilities
The cash ratio measures a company’s ability to pay off short-term liabilities with cash and cash equivalents:
Cash ratio = Cash and Cash equivalents / Current Liabilities
The operating cash flow ratio is a measure of the number of times a company can pay off current liabilities with the cash generated in a given period:
Operating cash flow ratio = Operating cash flow / Current liabilities
Leverage Financial Ratios
Leverage ratios measure the amount of capital that comes from debt. In other words, leverage financial ratios are used to evaluate a company’s debt levels. Common leverage ratios include the following:
The debt ratio measures the relative amount of a company’s assets that are provided from debt:
Debt ratio = Total liabilities / Total assets
The debt to equity ratio calculates the weight of total debt and financial liabilities against shareholders’ equity:
Debt to equity ratio = Total liabilities / Shareholder’s equity
Interest coverage ratio = Operating income / Interest expenses
The debt service coverage ratio reveals how easily a company can pay its debt obligations:
Debt service coverage ratio = Operating income / Total debt service
Efficiency Ratios
Efficiency ratios, also known as activity financial ratios, are used to measure how well a company is utilizing its assets and resources. Common efficiency ratios include:
The asset turnover ratio measures a company’s ability to generate sales from assets:
Asset turnover ratio = Net sales / Average total assets
The inventory turnover ratio measures how many times a company’s inventory is sold and replaced over a given period:
Inventory turnover ratio = Cost of goods sold / Average inventory
The accounts receivable turnover ratio measures how many times a company can turn receivables into cash over a given period:
Receivables turnover ratio = Net credit sales / Average accounts receivable
The days sales in inventory ratio measures the average number of days that a company holds on to inventory before selling it to customers:
Days sales in inventory ratio = 365 days / Inventory turnover ratio
Profitability Ratios
Profitability ratios measure a company’s ability to generate income relative to revenue, balance sheet assets, operating costs, and equity. Common profitability financial ratios include the following:
The gross margin ratio compares the gross profit of a company to its net sales to show how much profit a company makes after paying its cost of goods sold:
Gross margin ratio = Gross profit / Net sales
The operating margin ratio, sometimes known as the return on sales ratio, compares the operating income of a company to its net sales to determine operating efficiency:
Operating margin ratio = Operating income / Net sales
The return on assets ratio measures how efficiently a company is using its assets to generate profit:
Return on assets ratio = Net income / Total assets
The return on equity ratio measures how efficiently a company is using its equity to generate profit:
Return on equity ratio = Net income / Shareholder’s equity
Learn more about the different profitability ratios in the following video:
Market Value Ratios
Market value ratios are used to evaluate the share price of a company’s stock. Common market value ratios include the following:
The book value per share ratio calculates the per-share value of a company based on the equity available to shareholders:
Book value per share ratio = (Shareholder’s equity – Preferred equity) / Total common shares outstanding
The dividend yield ratio measures the amount of dividends attributed to shareholders relative to the market value per share:
Dividend yield ratio = Dividend per share / Share price
The earnings per share ratio measures the amount of net income earned for each share outstanding:
Earnings per share ratio = Net earnings / Total shares outstanding
The price-earnings ratio compares a company’s share price to its earnings per share:
Price-earnings ratio = Share price / Earnings per share
Related Readings
Thank you for reading CFI’s guide to financial ratios. To help you advance your career in the financial services industry, check out the following additional CFI resources:
CFI is a global provider of financial modeling courses and of the FMVA Certification. CFI’s mission is to help all professionals improve their technical skills. If you are a student or looking for a career change, the CFI website has many free resources to help you jumpstart your Career in Finance. If you are seeking to improve your technical skills, check out some of our most popular courses. Below are some additional resources for you to further explore:
CFI is a global provider of financial modeling courses and of the FMVA Certification. CFI’s mission is to help all professionals improve their technical skills. If you are a student or looking for a career change, the CFI website has many free resources to help you jumpstart your Career in Finance. If you are seeking to improve your technical skills, check out some of our most popular courses. Below are some additional resources for you to further explore:
Below is a break down of subject weightings in the FMVA® financial analyst program. As you can see there is a heavy focus on financial modeling, finance, Excel, business valuation, budgeting/forecasting, PowerPoint presentations, accounting and business strategy.
A well rounded financial analyst possesses all of the above skills!
Additional Questions & Answers
CFI is the global institution behind the financial modeling and valuation analyst FMVA® Designation. CFI is on a mission to enable anyone to be a great financial analyst and have a great career path. In order to help you advance your career, CFI has compiled many resources to assist you along the path.
In order to become a great financial analyst, here are some more questions and answers for you to discover:
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