Ultimate guide on Financial Ratios

Meaning of Ratio

Ratio is defined by Oxford Dictionary as “The relationship between two Amounts, Showing the number of times one value contains the others.”

Also as per Merriam Webster dictionary ratio indicates quotients of two Mathematical expressions or Relationships in quantity, amount, or size between two or more things i.e. Proportion.

Financial Ratios

Financial ratios or accounting ratios means the relationship between two selected accounting figures from the enterprise’s financial statements.

Ratio analysis will help you to carry out the following objectives:

  • You can evaluate the performance of the organization
  • You can also gain information about the strength and weaknesses of organizations
  • Based on the above 2 objectives you can take investment decisions in the organization.

While doing Ratio analysis you can not only just compare different figures from the Balance sheet, Income statement, and Cash flow statement. But can also compare the number against the previous years, Other companies, the industry, or even the economy in general for financial analysis.

Types of Financial Ratios

Broadly Financial ratios are classified into 4 types;

  1. Liquidity Ratio
  2. Leverage Ratio is also known as Debt ratio/Long-term solvency ratio
  3. Activity Ratio is also known as Performance/ Turnover ratio
  4. Profitability Ratio
  1. Liquidity Ratio

The liquidity ratio is also known as the “Short-term Solvency ratio”. It represents the ability of the business to pay its short-term debts. These ratios are mostly used by short-term lenders or Creditors of the organization to determine the ability of a business to repay its amount.

Following are various liquidity ratios that you can use:

  1. Leverage Ratio/ Debt Ratio/ Long-term Solvency Ratio

Leverage ratios are used to measure the Long-term stability and structure of the organization. These ratios are mainly used by Owners, Bankers, and long–term fund lenders to determine the organization’s ability to pay the Periodic interest during the tenure of the loan and also repayment of principal amount on maturity.

Following are various Leverage Ratio/Debt ratio/Long-term Solvency Ratio you can use:

  • Debt Ratio
  • Equity Ratio
  • Debt to Equity Ratio
  • Debt to Total Asset ratio
  • Proprietary Ratio
  • Capital Gearing Ratio
  • Interest Coverage Ratio
  • Preference Dividend Coverage Ratio
  • Debt Service Coverage Ratio
  • Fixed Charges Coverage Ratio
  1. Activity Ratio / Performance ratio/ Turnover Ratio

This ratio indicates how quickly a firm can convert its non-cash assets to cash assets. These ratios will also help you to evaluate how efficiently the firm manages and utilizes its assets. They are also known as “Asset Management Ratio”. These ratios usually indicate the number of times sales are generated in respect of the amount invested in Capital assets or Working capital or inventory.

Following are various types of Activity/ Performance/ turnover ratios you can use to evaluate the asset management of the organizations:

  • Total Assets Turnover Ratio
  • Capital Turnover Ratio
  • Current Assets Turnover Ratio
  • Fixed Assets Turnover Ratio
  • Working capital Turnover Ratio
  1. Profitability Ratio

The profitability ratio helps us to evaluate the profitability or operational efficiency of the firm. These are some of the most widely used ratios and are also being used by Investors to evaluate the organizations.

The profit earned by the organization can be evaluated by comparing it with various parameters such as Sales, Assets, Current market price of shares, etc.

The profitability ratio is classified into the following 4 categories:

  1. Profitability Ratio based on Sales
  • Gross Profit ratio
  • Net Profit Ratio
  • Operating Profit Ratio
  • Expenses ratio
  1. Profitability Ratio from the Shareholders point of View
  • Earnings per Share (EPS)
  • Dividend per Share (DPS)
  • Dividend payout ratio
  1. Profitability Ratio Related to Market price of Share
  • Price-earnings Ratio (PE)
  • Market Value per share
  • Dividend Yield Ratio
  1. Profitability Ratio based on Overall return on Assets/Investments
  • Return on Assets (ROA)
  • Return on Capital Employed (ROCE)
  • Return on Equity (ROE)