What are financial ratios?

Financial ratios are mathematical formulas that analyze a company's financial statements. Ratios can be used to evaluate a company's financial health and its profitability and growth potential. Financial ratios can also be used to compare a company's performance with that of its competitors.

Importance of financial ratios

Financial ratios are important tools that can be used to evaluate a company's financial health. Ratios provide insights into a company's profitability, solvency, and growth potential. Financial ratios can also be used to compare a company's performance with that of its competitors. Also, lenders and investors often use financial ratios to assess a company's creditworthiness.

• Financial ratios provide insights into a company's financial health.
• Financial ratios can be used to compare companies within an industry.
• Financial ratios can be used to identify trends over time.
• Financial ratios can serve as a good tool for assessing risk.
• Financial ratios are easy to calculate and interpret.

Types of financial ratios

There are dozens of different financial ratios that can be used to analyze a company's financial statements. However, some of the most commonly used ratios include:

Liquidity ratios

Liquidity ratios measure whether a company has enough funds to pay its short-term debts. The most common liquidity ratio is the current ratio, which is obtained when a company's current assets (such as cash and marketable securities) are divided by its current liabilities (such as accounts payable and short-term debt). Current assets are those assets that can be liquidated within twelve months, such as cash, marketable securities, inventory, and accounts receivable.

A company having a current ratio of less than 1 denotes liquidity issues because it does not have enough assets to pay its debts. Other liquidity ratios include the quick ratio (acid-test ratio) and the cash ratio. The quick ratio denotes the relationship of quick assets with the current assets, whereas the cash ratio is determined by dividing cash and cash equivalents by current liabilities.

Profitability ratios

Profitability ratios measure a company's ability to generate profits. The most common profitability ratio is the net profit margin, which is obtained when a company's net profits (after taxes) are divided by its total revenue.

A company that has a net profit margin of less than 5% is considered to be less profitable. Other profitability ratios include the operating profit margin and the return on equity (ROE).

Solvency ratios

Solvency ratios measure whether a company has enough funds to repay its long-term debts. The most common solvency ratio is the debt-to-equity ratio, which is obtained when a company's total liabilities are divided by its shareholder equity.

A company that has a debt-to-equity ratio of more than 1 denotes that a company's assets are backed by debt financing. Other solvency ratios include the interest coverage ratio and the debt-to-asset ratio.

Growth ratios

Growth ratios measure a company's ability to generate growth. The most common growth ratio is the earnings per share (EPS) growth rate, which is obtained when a company's earnings per share (EPS) are divided by its previous year's EPS.

A company that has an EPS growth rate of less than 5% is considered to be unprofitable. Other growth ratios include the revenue growth rate and the net income growth rate.

Disadvantages of using financial ratios

While financial ratios can be useful tools, they also have the following disadvantages:

• Financial ratios are based on a company's financial statements, which are often subject to accounting conventions and may not be entirely accurate.
• Financial ratios do not take into account a company's size or industry. For example, a company with a debt-to-equity ratio of two have good financial health if it is a small company. However, a company with the same debt-to-equity ratio would be considered to be in poor financial health if it is a large company.
• Financial ratios should not be used in isolation. For example, a company with a high debt-to-equity ratio might be considered to be in poor financial health. However, if the company has a high operating profit margin, then its financial health is considered a good financial position.
• Financial ratios can change over time, and they should be interpreted in the context of other information about the company. For example, a company's debt-to-equity ratio might increase over time as a company can raise more debt. However, if a company's profits also increase, the increased debt might not be a concern.

The bottom line is that financial ratios can be useful tools, but they should be used with caution. Ratios should not be used in isolation, and they should always be interpreted in the context of other information about the company.

Common Mistakes

Students generally make mistakes in understanding liquidity ratios and solvency ratios. Both financial ratios serve the same purpose of determining an organization's ability to make its debt payment, but both concepts are different. Liquidity ratios denote whether a company can make payments toward short-term debts, whereas solvency ratios denote whether a company can make payments toward long-term debts. They should analyze the technical difference between both concepts to eliminate this confusion.

Context and Applications

Financial ratios are a fundamental topic in business. Companies use financial ratios to ascertain their overall financial health and their ability to pay off short-term and long-term debts. The study of financial ratios is important for the following courses:

• Chartered Accountancy
• Master of Business Administration (Finance)
• Diploma in Corporate Finance
• Diploma in Cost Management Accounting

Related Concepts

• Capital assets
• Consumer debt
• Liquidity
• Profitability
• Return on investment

Practice Problems

1. Which one of the following isn't a part of current assets?

1. Stock inventory
2. Creditors
3. Debtors
4. Money in the bank

Answer: b

Explanation: The currents assets mentioned in a balance sheet get converted into cash within a year. They include cash in hand, cash at the bank, marketable securities, inventory, and debtors. Creditors are a part of the current liabilities of a company.

2. Companies measure financial ratios based on __________ .

1. Financial statements
2. Company's size
3. Size of the industry
4. Assumptions related to business growth

Answer: a

Explanation: Financial ratios are based on the financial statements of the company. Investors can determine the financial health of a company using financial ratios determined through financial statements.

3. Debt-equity is often categorized as __________.

1. Solvency ratio
2. Liquidity ratio
3. Turnover ratio
4. Fixed ratio

Answer: a

Explanation: The long-term solvency ratio is calculated by dividing the firm's revenue by the total liabilities of an organization. It involves the debt-equity ratio that depicts the level of debt in comparison with the amount of equity.

4. What is the other name for the ‘current ratio’?

1. Liquid-to-liquid ratio
2. The ratio of cash flow
3. The ratio of acid to base
4. Performance ratio

Answer: b

Explanation: The current ratio measures an industry's capacity to pay its debts and liabilities. The cash flow ratio is defined as current payment commitments that will be accomplished with cash flow from activities. It is the second name for the current ratio.

5. Which one of the following ratios is used to assess long-term liquidity?     

1. Profitability ratio
2. Valuation ratio
3. Performance ratio
4. Solvency ratio

Answer: d

Explanation: The solvency ratio calculates the organization’s ability to check whether sufficient funds are available for long-term liability. It also measures the total debt-to-equity in comparison to shareholder's equity.