What are Financial Ratios?
Financial ratios are created with the use of numerical values taken from financial statementsThree Financial StatementsThe three financial statements are the income statement, the balance sheet, and the statement of cash flows. These three core statements are intricately linked to each other and this guide will explain how they all fit together. By following the steps below you'll be able to connect the three statements on your own. to gain meaningful information about a company. The numbers found on a company’s financial statements – balance sheetBalance SheetThe balance sheet is one of the three fundamental financial statements. These statements are key to both financial modeling and accounting. The balance sheet displays the company’s total assets, and how these assets are financed, through either debt or equity. The balance sheet: Assets = Liabilities + Equity,income statementIncome StatementThe Income Statement (or Statement of Profit and Loss) shows performance from operations of a business. The financial statement begins with revenues and, and cash flow statementCash Flow StatementA Cash Flow Statement (officially called the Statement of Cash Flows) contains information on how much cash a company has generated and used during a given period. It contains 3 sections: cash from operations, cash from investing and cash from financing. See examples and detailed descriptions this guide 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 Ratio Analysis
Ratio analysis serves two main purposes:
1. Track company performance:
Determining individual ratios per period and tracking the change in their values over time is done to spot trends that may be developing in the 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 the 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’s assets are being used most efficiently.
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 measure a company’s ability to repay both short- and long-term obligations. Common liquidity ratios include the following:
The current ratioCurrent Ratio FormulaThe Current Ratio formula is = Current Assets / Current Liabilities. The current ratio, also known as the working capital ratio, measures the capability of a business to meet its short-term obligations that are due within a year. The ratio indicates the financial health of the company measures a company’s ability to pay off short-term liabilities with current assets:
Current ratio = Current assets / Current liabilities
The acid-test ratioAcid-Test RatioThe Acid-Test Ratio, also known as the quick ratio, is a liquidity ratio that measures how sufficient a company's short-term assets are to cover its current liabilities. In other words, the acid-test ratio is a measure of how well a company can satisfy its short-term (current) financial obligations. measures a company’s ability to pay off short-term liabilities with quick assets:
Acid-test ratio = Current assets – Inventories / Current liabilities
The cash ratioCash RatioCash ratio is a liquidity ratio that measures a company’s ability to pay off short-term debt obligations with cash and cash equivalents. Compared to other liquidity ratios such as current ratio or quick ratio, cash ratio is much more conservative, as it only uses cash and cash equivalents in the calculation. 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 ratioOperating Cash Flow RatioOperating cash flow ratio, a liquidity ratio, is a measure of how well a company can pay off its current liabilities with the cash flow generated from business operations. In other words, operating cash flow ratio shows how much a company earns from its operating activities per dollar of current liabilities. 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 Ratios
Leverage ratiosLeverage RatiosA leverage ratio indicates the level of debt incurred by a business entity against several other accounts in its balance sheet, income statement, or cash flow statement. Leverage ratios include debt/equity, debt/capital, debt/assets, debt/EBITDA, and interest coverage. This guide has exmaples and Excel template measure the amount of capital that comes from debt. In other words, leverage ratios are used to evaluate a company’s debt levels. Common leverage ratios include the following:
The debt ratioDebt to Asset RatioThe debt to asset ratio, also known as the debt ratio, is a leverage ratio that indicates the percentage of assets that are being financed with debt. The higher the debt to assets ratio, the greater the degree of leverage and financial risk. The debt to assets ratio is commonly used by creditors to determine measures the amount of a company’s assets that are provided from debt:
Debt ratio = Total liabilities / Total assets
The debt to equity ratioFinanceFinancial ratios, also known as accounting ratios, involve the use of numerical values taken from the financial statements to gain meaningful information about a company. The numbers found on a company’s financial statements – balance sheet, income statement, cash flow statement, are calculates the weight of total debt and financial liabilities against shareholders equity:
Debt to equity ratio = Total liabilities / Shareholder’s equity
The interest coverage ratioInterest Coverage RatioInterest Coverage Ratio (ICR) is a financial ratio that is used to determine the ability of a company to pay the interest on its outstanding debt. The ICR is commonly used by lenders, creditors, and investors to determine the riskiness of lending capital to a company. The interest coverage ratio is also called “times determines how easily a company can pay its interest expenses:
Interest coverage ratio = Operating income / Interest expenses
The debt service coverage ratio determines 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 ratios, are used to measure how well a company is utilizing its assets and resources. Common efficiency ratios include:
The asset turnover ratioAsset TurnoverAsset turnover is a ratio that measures the value of revenue generated by a business relative to its average total assets for a given fiscal or calendar year. It is an indicator of how efficient the company is using both the current and fixed assets to produce revenue. measures a company’s ability to generate sales from assets:
Asset turnover ratio = Net sales / Total assets
The inventory turnover ratioInventory TurnoverInventory turnover, or the inventory turnover ratio, is the number of times a business sells and replaces its stock of goods during a given period. It considers the cost of goods sold, relative to its average inventory for a year or in any a set period of time. 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 ratioDays Sales in Inventory (DSI)Days sales in inventory(SDI) indicates how many days it takes to sell or convert a company’s current stock into sales during a given period. Formula measures the average number of days that a company holds onto its inventory before selling it to customers:
Days sales in inventory ratio = 365 days / Inventory turnover ratio
Profitability Ratios
Profitability ratiosProfitability RatiosProfitability ratios are financial metrics used by analysts and investors to measure and evaluate the ability of a company to generate income (profit) relative to revenue, balance sheet assets, operating costs, and shareholders' equity during a specific period of time. They show how well a company utilizes its assets measure a company’s ability to generate income relative to revenue, balance sheet assets, operating costs, and equity. Common profitability ratios include the following:
The gross margin ratioGross Margin RatioThe Gross Margin Ratio, also known as the gross profit margin ratio, is a profitability ratio that compares the gross profit of a company to its revenue. It shows how much profit a company makes after paying off its Cost of Goods Sold (COGS). This ratio indicates the percentage of each dollar compares the gross profit of a company to its net sales to show how much profit a company makes after paying off its cost of goods sold:
Gross margin ratio = Gross profit / Net sales
The operating margin ratioOperating Profit MarginOperating Profit Margin is a profitability, or performance, ratio used to calculate the percentage of profit a company produces from its operations, prior to subtracting taxes and interest charges. It is calculated by dividing the operating profit by total revenue, and expressed as a percentage. 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 ratioReturn on Assets & ROA FormulaReturn on assets (ROA), a form of return on investment, measures the profitability of a business in relation to its total assets. The ROA formula is used to indicate how well a company is performing by comparing the profit it's generating to the capital it's invested in assets. The higher the return, the more measures how efficiently a company is using its assets to generate profit:
Return on assets ratio = Net income / Total assets
Thereturn on equity ratioReturn on Equity (ROE)Return on Equity (ROE) is a measure of a company’s profitability that takes a company’s annual return (net income) divided by the value of its total shareholders' equity (i.e. 12%). ROE combines the income statement and the balance sheet as the net income or profit is compared to the shareholders’ equity. measures how efficiently a company is using its equity to generate profit:
Return on equity ratio = Net income / Shareholder’s equity
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 equity available to shareholders:
Book value per share ratio = Shareholder’s equity / Total 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 ratioPrice Earnings RatioThe Price Earnings Ratio (P/E Ratio) is the relationship between a company’s stock price and earnings per share. It gives investors a better sense of the value of a company. The P/E shows the expectations of the market and is the price you must pay per unit of current (or future) earnings. Learn the formula, examples compares a company’s share price to the earnings per share:
Price-earnings ratio = Share price / Earnings per share
Related Readings
CFI is the official global provider of the Financial Modeling & Valuation Analyst (FMVA)™FMVA™ CertificationThe Financial Modeling & Valueation Analyst (FMVA)™ accreditation is a global standard for financial analysts that covers finance, accounting, financial modeling, valuation, budgeting, forecasting, presentations, and strategy. certification program for investment banking professionals. To help you advance your career in the financial services industry, check out the following additional resources:
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