Financial Ratios are indicators computed as a proportion of one financial value to another highly relevant financial value. They are used to analyze financial position i.e. liquidity and solvency, and financial performance i.e. profitability and efficiency of a company.
Key information about a company’s sales, cost of sales, gross profit, net income, total assets, total liabilities, etc. appear on its financial statement, namely balance sheet, income statement and/or the cash flow statement. However, these statements offer absolute values. It is useful to standardize relationship between different financial metrics because it makes comparison easier over time for a single company (trend analysis) and between different companies in the same industry (i.e. cross-sectional analysis).
It is important that the two figures being compared must make intuitive sense. For example, it makes sense to compare current assets with current liabilities because one pays off another, but it is not very useful to compare current assets with non-current assets because there is no relatable link between both.
Financial ratios are broadly categorized based on the aspect of a company’s financial health they intend to measure. These categories include liquidity ratios, solvency ratios, profitability ratios and efficiency (also called asset utilization) ratios.
Liquidity ratios are ratios that measure the ability of a company to meet its short-term financial obligations. These include current ratio and quick ratio (also called acid-test ratio).
Solvency ratios are ratios used to assess the long-term financial position of a company. These include debt ratio, debt to equity ratio, times interest earned, financial leverage ratio, fixed charge coverage ratio, etc.
Profitability ratios measure a company’s ability to generate profit. They compare different measures of income (gross profit, EBITDA, operating income, earnings before taxes, net income) to net revenue or assets or equity, etc. Most common profitability ratios are gross profit margin, net margin, return on assets, return on equity, return on total capital, dividend payout, dividend yield, etc. Some profitability ratios that assess the capital market performance of a company attempt to measure how cheap or expensive a company’s stock is with reference to other companies, these include earnings per share, price to earnings ratio, price to book value ratio, price to sales, etc.
Efficiency ratios (also called asset-utilization ratios) are ratios that assess how efficiently the company is using its assets to generate revenue and income. Typical efficiency ratios include fixed asset turnover ratio, inventory turnover ratio, receivables turnover ratio, operating cycle, cash cycle, etc.