Financial ratio

A Financial ratio is a quantitative measure calculated from financial statement data to evaluate aspects of a company's financial performance, financial position, or operating characteristics. Financial ratios are commonly used in financial analysis to compare companies, assess changes over time, and evaluate financial risks and returns.

A simplified representation is:

$\text{Financial Ratio}=\frac{\text{Financial Measure A}}{\text{Financial Measure B}}$

The measures used in the numerator and denominator depend on the purpose of the ratio.

Uses

Financial ratios can be used to:

• evaluate profitability;
• assess liquidity;
• measure financial leverage;
• evaluate operating efficiency;
• assess the ability to service debt;
• compare companies within an industry;
• identify changes in financial performance;
• support investment and credit analysis.

Ratios are generally most informative when interpreted in the context of a company's industry, business model, historical performance, and accounting policies.

Types of financial ratios

Financial ratios are commonly grouped into several categories:

• liquidity ratios;
• profitability ratios;
• leverage ratios;
• efficiency ratios;
• market ratios;
• solvency ratios.

The classification can vary among financial-analysis frameworks.

Liquidity ratios

Liquidity ratios measure an entity's ability to meet short-term obligations.

The Current ratio is:

$\text{Current Ratio}=\frac{\text{Current Assets}}{\text{Current Liabilities}}$

The Quick ratio is:

$\text{Quick Ratio}=\frac{\text{Quick Assets}}{\text{Current Liabilities}}$

The Cash ratio is:

$\text{Cash Ratio}=\frac{\text{Cash and Cash Equivalents}+\text{Marketable Securities}}{\text{Current Liabilities}}$

These ratios differ according to the liquidity of the assets included in the numerator.

Profitability ratios

Profitability ratios measure a company's ability to generate earnings relative to revenue, assets, equity, or invested capital.

The net profit margin is:

$\text{Net Profit Margin}=\frac{\text{Net Income}}{\text{Revenue}}\times 100$

The Return on assets (ROA) is commonly expressed as:

$\text{ROA}=\frac{\text{Net Income}}{\text{Average Total Assets}}\times 100$

The Return on equity (ROE) is:

$\text{ROE}=\frac{\text{Net Income}}{\text{Average Shareholders' Equity}}\times 100$

The use of average assets or average equity can reduce distortions caused by changes in the balance sheet during the reporting period.

Leverage ratios

Leverage ratios measure the extent to which a company uses debt or other financial obligations relative to its assets or equity.

The Debt-to-equity ratio is:

$\text{Debt-to-Equity Ratio}=\frac{\text{Total Debt}}{\text{Shareholders' Equity}}$

The debt-to-assets ratio is:

$\text{Debt-to-Assets Ratio}=\frac{\text{Total Debt}}{\text{Total Assets}}\times 100$

Higher leverage can increase potential returns to equity holders but can also increase financial risk.

Coverage ratios

Coverage ratios assess an entity's ability to meet specific financial obligations from earnings or cash flow.

The Interest coverage ratio is commonly expressed as:

$\text{Interest Coverage Ratio}=\frac{\text{EBIT}}{\text{Interest Expense}}$

The Debt service coverage ratio (DSCR) can be represented as:

$\text{DSCR}=\frac{\text{Cash Flow Available for Debt Service}}{\text{Debt Service}}$

A higher coverage ratio generally indicates greater capacity to meet the corresponding financial obligation, although interpretation depends on the methodology and industry.

Efficiency ratios

Efficiency ratios measure how effectively a company uses its assets and working capital to generate revenue.

The Asset turnover ratio is:

$\text{Asset Turnover}=\frac{\text{Revenue}}{\text{Average Total Assets}}$

The Inventory turnover ratio can be calculated as:

$\text{Inventory Turnover}=\frac{\text{Cost of Goods Sold}}{\text{Average Inventory}}$

The Accounts receivable turnover ratio is:

$\text{Receivables Turnover}=\frac{\text{Net Credit Sales}}{\text{Average Accounts Receivable}}$

Higher turnover generally indicates more rapid utilization or conversion of the relevant asset, although the appropriate level varies by industry.

Market ratios

Market ratios relate a company's financial performance or accounting measures to its market value.

The Price-to-earnings ratio (P/E) is:

$\text{P/E Ratio}=\frac{\text{Market Price per Share}}{\text{Earnings per Share}}$

The Price-to-book ratio (P/B) is:

$\text{P/B Ratio}=\frac{\text{Market Price per Share}}{\text{Book Value per Share}}$

The Dividend yield is:

$\text{Dividend Yield}=\frac{\text{Dividend per Share}}{\text{Market Price per Share}}\times 100$

Market ratios are influenced by both company fundamentals and market expectations.

Solvency ratios

Solvency ratios assess an entity's ability to meet its longer-term financial obligations.

A simplified solvency ratio is:

$\text{Solvency Ratio}=\frac{\text{Total Assets}}{\text{Total Liabilities}}$

Other measures, such as debt-to-equity and interest coverage ratios, may also be used to evaluate long-term financial risk.

Solvency ratios should be distinguished from liquidity ratios, which primarily focus on short-term obligations.

DuPont analysis

DuPont analysis decomposes Return on equity into several components.

A simplified three-factor formulation is:

$\text{ROE}=\frac{\text{Net Income}}{\text{Revenue}}\times \frac{\text{Revenue}}{\text{Average Total Assets}}\times \frac{\text{Average Total Assets}}{\text{Average Shareholders' Equity}}$

This can be expressed as:

$\text{ROE}=\text{Net Profit Margin}\times \text{Asset Turnover}\times \text{Equity Multiplier}$

The decomposition illustrates how profitability, asset utilization, and financial leverage can contribute to return on equity.

Comparative analysis

Financial ratios are commonly used for comparative analysis.

A ratio can be compared:

• across different periods for the same company;
• with industry averages;
• with direct competitors;
• with historical benchmarks;
• with financial covenants or other thresholds.

A simplified time-series comparison is:

${\text{Ratio}}_t\text{versus}{\text{Ratio}}_{t-1}$

A cross-sectional comparison can be represented as:

$\text{Company Ratio}\text{versus}\text{Industry Ratio}$

Changes in a ratio can provide useful information, but the underlying financial statements should also be examined to determine the causes of the change.

Limitations

Financial ratios have several limitations.

Accounting policies can affect the values used in ratio calculations. Companies may also have different business models, capital structures, reporting periods, or accounting estimates, making direct comparisons difficult.

Other limitations include:

• ratios generally rely on historical financial information;
• inflation can affect comparisons across periods;
• seasonal businesses can produce misleading period-end ratios;
• one-time events can distort financial measures;
• ratios may not capture qualitative factors;
• market-based ratios can change substantially with share prices;
• different definitions of the same ratio can produce different results.

Consequently, financial ratios are generally used together with financial statements, cash-flow analysis, industry analysis, and other valuation or risk measures.

Financial ratios and financial analysis

Financial ratios form one component of broader financial analysis.

A simplified analytical framework is:

$\text{Financial Statements}\to \text{Financial Ratios}\to \text{Comparative Analysis}\to \text{Financial Assessment}$

Ratios can help identify trends and relationships but do not by themselves establish the underlying causes of financial performance.

See also

• Financial analysis
• Financial statement
• Financial accounting
• Liquidity ratio
• Profitability ratio
• Leverage ratio
• Efficiency ratio
• Market ratio
• Solvency ratio
• Return on equity
• Current ratio
• Quick ratio
• Debt-to-equity ratio
• Price-to-earnings ratio
• DuPont analysis