Financial ratios, also known as accounting ratios, are an essential aspect of financial reporting, taking rudimentary numbers on business performance and converting them into quantitative assessments that can track everything from changes in performance to how the organisation compares to market standards.
These ratios are used in the creation of the primary three financial statements – that’s the income statement, balance sheet, and cash flow statement.
Financial Ratio Categories
There are several different financial ratios, organised into different categories that collectively assess the business in one of these areas:
Profitability
Liquidity
Leverage or Solvency
Efficiency
Market Value
While each of the ratios is calculated individually in its own right, they are often used in combination or conjunction with other ratios in the same category to more completely analyse financial performance and health.
To best understand these ratios, we will explore them in the context of the category they belong to.
Profitability Ratios
Profitability ratios are key indicators of the financial success of a business, evaluating profit generation relative to revenue. Assessing sales, assets and equity, these ratios also evaluate balance sheet assets, operating costs, and equity. This includes ratios that analyse profit margin as well as returns on equity and assets.
Gross Profit Margin
This ratio indicates gross profit by comparing gross income, calculated by subtracting revenue from cost of goods sold (Revenue – COGS), to revenue. The output is the percentage of revenue that the company retains in profit for each dollar of total revenue.
Gross Profit Margin = Gross Income / Revenue
Operating Profit Margin
This ratio indicates the operational efficiency of an organisation by comparing the operating profit to total revenue. The output percentage is the efficiency with which core business operations are ran.
Operating Profit Margin = Operating Profit / Revenue
Net Profit Margin
This ratio shows overall profitability for an organisation. Net income, that being income with operating expenses, taxes and interest remove, is compared against total revenue to provide profitability percentage.
Net Profit Margin = Net Income / Revenue
Return on Assets
The return on assets ratio (ROA) provides an assessment of asset efficiency for profit. The output provides a percentage figure for how efficient the business is at utilizing their assets for profit generation – the higher the figure, the more efficient they are.
Return on Assets = Net Income / Total Assets
Return on Equity
ROE or Return on Equity rates how effective the business is at using shareholder investment (equity) to generate profit. This allows investors to determine how profitable their investment is.
Return on Assets = Net Income / Shareholder’s Equity
Liquidity Ratios
This set of ratios measures the business’ ability to meet short-term and long-term debt obligations. The short-term ratios are often used to determine whether debts for the upcoming year can be covered.
Current Ratio
The current ratio compares current assets with current liabilities, providing a simple snapshot as to whether the company could pay off debts with existing assets.
Current Ratio = Current Assets / Current Liabilities
Acid-Test Ratio
The acid test or quick ratio assesses whether a business could pay off current obligations without any inventory sales (Cash + Marketable Securities + Accounts Receivables). This is a more stringent way of calculating liquidity.
Current Ratio = (Current Assets – Inventory) / Current Liabilities
Cash Ratio
The cash ratio calculates whether an organisation could cover current obligations with just the company’s most liquid assets.
Cash Ratio = (Cash + Marketable Securities) / Current Liabilities
Operating Cash Flow Ratio
Operating cash flow provides a more long-term analysis of obligation repayment, measuring the number of times a company could pay off obligations within a given time period. The operating cash flow is calculated for the period wanting to be assessed.
Operating Cash Flow Ratio = Operating Cash Flow/ Current Liabilities
Leverage or Solvency Ratios
Solvency ratios, also known as Leverage ratios, evaluate the solvency of a business including debt levels, ability to meet long-term obligations, and general financial stability.
Debt to Assets Ratio
Also known simply as the Debt Ratio, Debt to Assets measures the percentage of assets that are funded by debt. This is a core measure of risk level of the business’ financial structure.
Debt to Asset Ratio = Total Liabilities / Total Assets
Debt to Equity Ratio
The Debt-to-Equity ratio evaluates what proportion of the business’ total financing comes from shareholder investment compared to debt. The higher the percentage of leverage, the more risk.
Debt to Equity Ratio = Total Liabilities / Shareholder’s Equity
Interest Coverage Ratio
Interest Coverage provides an assessment of how easily a business can pay interest expenses from obligations using current operating income.
Interest Coverage Ratio = Operating Income / Interest Expenses
Efficiency Ratios
This ratio category, also known as Activity Ratios, focuses on evaluating the efficiency with which a business uses assets and resources. This is commonly used as a assessment of management effectiveness.
Asset Turnover Ratio
This ratio assesses how efficiently revenue is generated through existing assets, with a higher ratio indicating more efficient asset utilization.
Asset Turnover Ratio = Revenue / Total Assets
Inventory Turnover Ratio
The inventory turnover ratio measures the rate at which current inventory is completely sold and replaced (costs of goods sold). A higher ratio means more efficient inventory management.
Inventory Turnover Ratio = COGS / Average Inventory
Receivables Turnover Ratio
Also known as the Accounts Receivable Turnover Ratio, this ratio measures how quickly a company collects receivables and therefore how quickly they can be converted into cash in a set period of time.
Receivables Turnover Ratio = Net Credit Sales / Average Accounts Receivable
Days Sales Outstanding
DSO measures the average time period in which payment is collected after sale completion. A lower number of days in which a sale is outstanding, the quicker cash is collected.
Days Sales Outstanding = (Accounts Receivable / Total Credit Sales) × Number of Days
Market Value Ratios
Finally, Market Value ratios compare the financial performance of a business to the stock market to determine share prices, dividends, and more.
Price to Book Ratio
The “P/B” ratio compares market value to book value to determine the accuracy of the current valuation of the business. A higher ratio suggests overvaluation, with a lower ratio indicating undervaluation.
Price to Book Ratio = Price per Share / Book Value per Share
Earnings Per Share
Earnings per Share or EPS measures the profit allocated to each individual share of the company.
Earning Per Share Ratio = Net Earnings / Total Shares Outstanding
Price to Earnings
The “P/E” shows the relationship between a company’s share price and its earnings. This is another ratio that can indicate how accurate the current valuation of shares is.
Price to Earnings Ratio = Price Per Share / Earnings Per Share
Dividend Yield
Dividend yield ratio measures the dividend that investors receive relative to the share price.
Dividend Yield = Dividend per Share / Price per Share
Further Reading on Financial Ratios
Knowledge of all these ratios is crucial to learning about financial reporting processes and creating different financial statements.
For more information and to continue learning around financial ratios, take a look at these additional guides.
