INTRODUCTION TO FINANCIAL RATIOS
Financial health & operational efficiency are often the key indicators for investors to judge on how an organization is going to perform in future. Analysts keep track of these using a variety of financial & operational metrics called financial ratios.
Financial ratios can be broadly listed under following categories:-
- Profitability ratios (How good a company is at making money?)
- Activity ratios/ Asset utilization ratios (Measures operational efficiency of the company)
- Liquidity ratios (How comfortable a company is to pay its debt in the short term?)
- Solvency ratios (How comfortable a company is to pay its debt in the long term?)
- Valuation ratios (Used for investment decisions by comparing two or more companies within the same industry)
1. PROFITABILITY RATIOS
Profitability ratios indicate how good a company is in making money and generating returns for its shareholders.
Profitability ratios on a broader note can be classified into two categories. The first category discussed below talks about profitability ratios that are based on sales return –
Based on Return of Sales
- Gross margin %
- Operating margin %
- Pre-tax margin %
- Net profit %
Next category of Profitability ratios discussed below talks about ratios that are based on return on investment (ROI).
Return on investment (ROI) for any business activity can be calculated by dividing Net income with Investment. The term investment can be interpreted in three different ways while conducting a financial analysis. Therefore three different ratios namely return on assets, return on invested capital & return on shareholders’ equity are often used by analysts to evaluate companies.
Based on Return on Investment
- Return on Assets (ROA)
- Return on invested capital (ROIC)
- Return on Equity (ROE)
2. LIQUIDITY RATIOS
Liquidity ratios highlight a company’s health by determining how well it is placed to pay its debt in the short term without raising any external capital. Popular liquidity ratios used by analyst are listed below –
- Current Ratio
- Quick Ratio
3. SOLVENCY RATIOS
Solvency ratios highlight a company’s health by determining how well it is placed to pay its debt in the long term. Popular solvency ratios used by analyst are listed below –
- Debt/ Equity Ratio
- Debt/ Capitalization Ratio
- Times Interest Earned
4. ACTIVITY RATIOS
“Activity ratios” measures the operational efficiency of the company. These ratios are useful for managers in managing and improving day to day operations of the company. Popular activity ratios used by analysts are listed below –
- Inventory turnover ratio
- Asset turnover ratio
- Invested capital turnover ratio
- Equity Turnover ratio
- Capital asset Intensity ratio
- Working capital turnover ratio
- Accounts receivable turnover ratio
- Days Inventory
- Days Cash on hand
- Days receivables (or Collection Period)
- Days Payable
5. VALUATION RATIOS
“Valuation ratios” are often used by small & medium investors for determining overall financial health of the company. The ratios are also used for comparing two or more companies within the same industry before making an investment decision. Popular valuation ratios are listed below –
- Earnings per share (EPS)
- Price/ earnings (P/E) ratio
- Dividend Yield
- Dividend Payout
In the upcoming sections, we will be discussing about each of these ratios in detail, their interpretation & significance in real business scenarios.