According to financial theories, a financial ratio is a ratio of chosen numerical quantities picked up from the financial statements of a company. A large number of standardized financial ratios are utlized for the assessment of the financial state of a company.
The financial ratios are applied by the probable and present shareholders of a company, the creditors of a company and the managers of a company. Financial ratios are also used by security analysts for the purpose of comparison between the positives and negatives of different firms.
When the trading of shares of a particular firm is going on in the financial market, the market value of the stocks is utilized for specific financial ratios.The numerical quantities implemented in measuring financial ratios are picked up from income statements, balance sheets, statement of retained earnings (on rare occasions) and cash flow statements.
Collectively they form the financial statements or accounting statements of a company. At all times, the financial ratios are represented in the form of a decimal quantity, for example 0.50. or the similar percentage quantity, for example 50%.
Financial ratios measure a number of features of a commercial enterprise and they form an inherent portion of the analysis of financial statements. Financial ratios are classified depending on the financial features of the institution that the ratio calculates. Liquidity ratios calculate the accessibility of cash for payment of loans. Activity ratios compute how fast a company can exchange cash properties with non-cash properties. Debt ratios calculate the capability of a company to pay off its long-term loans. Profitability ratios compute the application of the properties of a company and handling of its disbursals for yielding a satisfactory rate of return. Market ratios compute the feedback from the investors with regards to possessing the shares of a company and in addition, the expenses related to the issuance of stock.
Financial ratios help in carrying out the following comparisons:
Between a particular firm and the industry average of the firm
Between various periods of time for a firm
Calculation of financial ratios is done on the basis of summarized data taken from financial statements. Distinctive standard accounting practices and accounting methods are utilized by different companies for the purpose of computation of financial ratios. The majority of public companies has to apply GAAP or generally accepted accounting principles for their domicile nations. Big transnational companies can implement International Financial Reporting Standards for preparing the financial statements.
The financial ratios of companies belonging to various sectors that experience several types of risks, necessities of capital, as well as contest are not corresponding in nature.
The financial ratios can be categorized into the following types:
Operating income margin or Operating margin = Operating income/Net sales
Return on Sales (ROS) or Operating profit margin = Earnings before interest and taxes/Sales = Operating earnings/Net sales
Gross profit rate or Gross profit margin = (Net sales – Cost of goods sold)/Net sales
ROE or Return on equity = Net profits after taxes/Shareholders’ equity or tangible net worth = Net profit/Equity
Net profit margin = Net profits after taxes/Sales
Asset turnover = Sales/Assets
Return on investment (Du Pont ratio or ROI ratio) = Net income/Total assets
Return on net assets (RONA)
Return on assets (ROA)
Risk adjusted return on capital (RAROC)
Return on capital (ROC)
Return on capital employed (ROCE)
Cash flow return on investment (CFROI)
Average collection period = Accounts receivable/(Annual credit sales/360 days)
Inventory turnover ratio = Cost of goods sold/Average inventory
Collection period (period end)
Inventory conversion ratio = Inventory conversion to cash period (days) = 360 days/Inventory turnover
Average payment period = Accounts payable/(Annual credit purchases/360 days)
Acid-test ratio (Quick ratio) = (Current assets – Inventories)/Current liabilities
Current ratio = Current assets/Current liabilities
Payout ratio = Dividend/Earnings or = Dividend per share/Earnings per share
It is noteworthy that earnings per share is not a financial ratio, rather it is a value expressed in currency.
Earnings per share = Expected earnings/Number of outstanding share
Price/cash flow ratio or Cash flow ratio = Price of stock/present value of cash flow per share
P/E ratio = Price/Earnings per share
Price to book value ratio (PBV or P/B) = Price of stock/Book value per share
Debt to assets ratio
Debt ratio = Total liabilities/Total assets
Long-term debt/Total asset (LD/TA) ratio = long-term debt/Total assets
Debt to equity ratio = (Long-term debt + Value of leases)/Shareholders’ equity
Overall coverage ratio = Cash inflows divided by
Interest charges plus
Lease expenses plus
Debt repayment/(1-t) plus
Times interest-earned ratio = Earnings before interest and taxes or EBIT/Annual interest expense
Debt service coverage ratio = Net operating income/Total debt service
For more information please refer to the following links:
Last Updated on : 27th June 2013