An Overview of Financial Ratios

Introduction

Financial ratios are a key tool to assess a business’s performance and overall health. These ratios compare different aspects of the business’s performance, such as profits, liquidity, operational efficiency, and leverage. By measuring and comparing different aspects of financial performance, financial ratios help business owners and investors to determine the strengths and weaknesses of their organization.

There are several types of financial ratios, each intended to measure a different aspect of financial performance. Broadly, these financial ratios can be classified into two main types: liquidity ratios and profitability ratios.

Liquidity Ratios

Liquidity ratios measure a business’s ability to meet its short-term financial obligations. These ratios measure the amount of liquid assets the business has available compared to its short-term liabilities. Examples of liquidity ratios include quick ratio, current ratio, and cash ratio.

Profitability Ratios

Profitability ratios measure the efficiency and effectiveness of a business’s operations. These ratios measure the business’s ability to generate profits from its resources and operations. Examples of profitability ratios include gross profit margin, net profit margin, and return on assets.

Asset Management

Asset management ratios measure a company’s ability to manage its assets and liabilities. The two common ratios used to measure a company’s asset management are the current ratio and the quick ratio.

Current Ratio

The current ratio, also known as the working capital ratio, measures a company's ability to pay current liabilities with current assets. It is calculated by dividing total current assets by total current liabilities. A ratio of 1.5 is often considered acceptable, meaning that the company has enough current assets to generate enough cash to pay current liabilities when they come due.

Quick Ratio

The quick ratio, also referred to as the acid-test ratio, measures a company’s liquidity enforcing a stricter measure than the current ratio. To calculate the quick ratio, subtract inventories, prepaid expenses and other current assets that are difficult to quickly convert to cash from total current assets and divide by total current liabilities. A ratio of 1.2 or higher indicates that the company has adequate liquidity to pay current liabilities.

Debt Management

Debt management is an important factor in the financial health of a business. The financial ratios used to gauge the level of a company’s debt are important tools to assess the risk of a company in taking on additional debt. A company’s ability to effectively manage its debt obligations is indicative of its financial health.

Debt to Equity

The debt to equity ratio is a measure of a public company’s total debt relative to its total equity. This ratio shows the company’s reliance on debt financing, and the capacity of its shareholders’ equity to cover its obligations. A higher ratio can indicate that the company is taking on too much risk or might be forced to declare bankruptcy if it cannot service its debt obligations.

Interest Coverage

Interest coverage is a measure of a company’s ability to make payments on the interest accrued in its debt. This ratio compares the earnings before interest and taxes (EBIT) to the amount of interest owed. A higher number indicates that the company can handle its debt payments without issue, while a lower number can indicate a potential inability to pay or an over-leveraged company.

Profitability and Market Analysis

Investors generally focus on two aspects when evaluating a company: profitability and its stock market performance. How profitable the company is determines whether or not investors are getting their desired return on investment (ROI). They also consider the company's current stock market performance and future projections, to make more informed decisions.

Return on Investment

Return on Investment (ROI) is a popular financial ratio used by investors to evaluate their investment's performance. It is a metric that measures the profitability of an investment and is calculated by subtracting the cost of the investment from the total return, then dividing the result by the initial cost. This ratio is important for assessing whether or not the investment is generating positive results for the investor.

Earnings Per Share

Another important financial ratio that investors look at is Earnings Per Share (EPS). This metric gives an insight into a company's profitability and the value of one share of the company's stock. It is calculated by dividing the company's after-tax net income by the outstanding shares of the company's stock. This metric provides investors with an understanding of how much profit each share of the company's stock generates.

EPS is an important financial ratio for investors and is used to compare different companies in the same industry, as it gives them an insight into the company's performance and the potential future earnings.

• Return on Investment (ROI): A metric that measures the profitability of an investment.
• Earnings Per Share (EPS): A metric that gives an insight into a company's profitability and the value of one share of the company's stock.

Liquidity

Liquidity is a measure of a company's ability to pay its current liabilities with its current assets. This metric is important for gauging a company's short-term financial position. It is essential for investors, lenders, and creditors to understand a company’s liquidity because it signifies the company’s financial health and ability to pay its debts. The two common metrics used to measure liquidity are cash flow to current liabilities and cash flow coverage.

Cash Flow to Current Liabilities

Cash flow to current liabilities is a liquidity ratio that measures the ability of a company to meet its current liabilities with its current assets. Specifically, it is calculated by dividing the net cash flow from operating activities by its current liabilities. This ratio highlights how much cash is leftover from operations to use as a source of working capital.

Cash Flow Coverage

Cash flow coverage is a liquidity ratio that measures a company’s ability to use its current cash flow to pay its current liabilities. It is calculated by dividing the net cash flow from operating activities by total current liabilities. This ratio indicates how many times the current liabilities can be satisfied by current cash flow. A ratio of greater than one indicates that the company’s current cash flow is greater than its current liabilities.

Efficiency

Efficiency ratios measure how well a company is managing their assets relative to their revenues. These ratios are vital when assessing how well a company is organized in terms of their inventory, accounts receivable, and other assets. Below are two key ratios related to efficiency: Inventory Turnover and Accounts Receivable Turnover.

Inventory Turnover

Inventory Turnover measures how quickly a company is able to move its inventory. This ratio is calculated by dividing the Cost of Goods Sold by the Average Inventory. A higher ratio indicates that the company is able to move its inventory quicker, resulting in higher profits.

Accounts Receivable Turnover

Accounts Receivable Turnover measures how quickly a company is able to collect payments from its customers. This ratio is calculated by dividing Total Sales by the Average Accounts Receivable. A higher ratio indicates that the company is able to collect payments quicker, resulting in higher profits.

Conclusion

Financial ratio analysis is an useful tool to judge the strength and performance of a business, while also providing insight into potential areas of improvement. Evaluating financial ratios at regular intervals ensures that investors and company stakeholders are consistently up to date with the latest financial trends, in order to make sound decisions moving forward.

Benefits of Analyzing Financial Ratios

• It allows investors and company stakeholders to track financial trends and benchmark performance against that of industry competitors.
• It can provide valuable insights into areas of potential improvement, so that corrective action can be taken.
• It helps in assessing future performance and risk factor.
• It enables the efficient use, and tracking, of limited financial resources.

Importance of Regularly Tracking Financial Ratios

Regularly tracking financial ratios is a key component of good financial management. By doing so, companies can ensure that their finances correctly reflect the current state of the business, to best inform their decision making. Additionally, industry peers can be compared to monitor potential areas of improvement, as well as stay aligned with market trends.