Financial Ratios Cheat Sheet: A Complete Guide to All Ratios
Financial ratios are powerful tools used to analyze and interpret financial statements, providing valuable insights into a company's performance, efficiency, and financial health. This article will cover all the existing financial ratios that help in analyzing the financial situation of a company.
Table of Contents
- About Financial Ratios
- Uses
- Types of Financial Ratios
- Limitations of Financial Ratios
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What is a financial ratio?
Financial ratios are the relative measurement of two numerical values. These values are extracted from the financial statement of the company to analyse its financial health. Different ratios measure the company’s financial state in a specific sense.
Let us consider the margin of safety. This ratio measures whether the company is in profit, break-even or in a loss state. One of the financial ratios leverage assesses if the company is capable of meeting financial obligations.
Uses of the Ratio
Experts use financial ratios for analysis of the financial situation of the company. These ratios allow for comparison among:
- Companies
- Same company at two different time periods
- Industries
- Company and its industry average
These ratios must be benchmarked against something such as the company’s past performance. Only then, it will be useful. These are not useful for companies that belong to different industries or have different capital requirements.
These can be expressed in the value of decimals or in percentages. For all ratios, experts take numerical values from income statements, balance sheets, statements of cash flows and sometimes from statements of changes in equity. Let us now learn about each ratio in detail.
Types of Financial Ratios
There are many types of ratios and each one signifies a part of a company’s financial health. These are categorised as:
- Efficiency ratios
- Leverage ratios
- Liquidity ratios
- Profitability ratios
1. Efficiency Ratio
The efficiency or activity financial ratio measures how well the organisation is optimising its assets. Following are the different types of efficiency ratios:
- Asset turnover ratio
- Accounts receivable turnover ratio
- Inventory turnover ratio
- Days sales in inventory ratio
1. Asset Turnover Ratio
In simple words, it measures the ability to generate sales from assets.
Asset turnover ratio = Net sales / Average total assets
This ratio measures the value of the revenue generated in comparison with the average total assets for a fiscal year. Average total assets include the initial and final balance of the company’s assets. It indicates how efficiently the company is using its fixed and current assets for revenue generation. These include current, fixed and intangible assets as well as long term investments.
Let us understand this financial ratio through an example.
At the end of the fiscal year on December 31, 2015, a company declared the following in its financial statements:
- Total assets ending balance: $350M,
- Beginning balance: $250M
- Average asset result for that year: $300M ($250M+$350M/2)
- Total revenues reached: $600M generated from main business activities
- The asset turnover: 2 ($600M/$300M)
2. Accounts Receivable Turnover
The accounts receivable turnover is one of the financial ratios for analysis of the number of times a company can turn its receivables into cash over a time period. This ratio is used for measuring the company’s efficiency of collecting on the credit that they provide to their customers.
Receivables turnover ratio = Net credit sales / Average accounts receivable
3. Inventory Turnover Ratio
The inventory ratio indicates the number of times the business sells and replaces the goods during a particular time period. If the inventory turnover ratio is high, it means the goods are selling fast. If this financial ratio is low, then it means that goods are selling slowly indicating that the business is not growing.
Inventory turnover ratio = Cost of goods sold / Average inventor
4. Days Sales in Inventory (DSI)
It is a financial ratio for the analysis of the average number of days that are required by a business for converting its inventory into sales figures. For calculation purposes, the goods considered as ‘work in progress’ (WIP) are included in inventory. This ratio also determines the average days required by the company for converting its resources into cash flows.
DIS= (inventory/cost of goods sold) x number of days
2. Leverage Ratio
The leverage ratio measures whether the company can meet its financial obligations. It indicates the amount of capital coming from debt. Once you are aware of this amount, you can evaluate whether a company can pay its due debts.
It indicates how the assets and business operations of company assets are financed. There are different types of leverage ratios, including the following five:
- Asset-to-Equity= Total Assets / Total Equity
- Debt-to-Assets= Total Debt / Total Assets
- Debt-to-Capital= Today Debt / (Total Debt + Total Equity)
- Debt-to-Equity = Total Debt / Total Equity
- Debt-to-EBITDA = Total Debt / Earnings Before Interest Taxes Depreciation & Amortization (EBITDA)
3. Liquidity Ratios
These financial ratios analyse the company’s capability to repay short-term and long-term obligations. The following are the common liquidity ratios:
- Acid-test ratio
- Cash ratio
- Current ratio
- Operating cash flow ratio
1. Acid-test ratio
An acid test or quick ratio is a financial ratio that measures the ability of a company’s short-term assets to cover current financial obligations.
Acid-test ratio= (Cash & Cash Equivalents + Accounts Receivables + Market Securities)/ current liabilities
or
Acid-test ratio= (current assets – inventories)/current liabilities
Related Read – Solvency Ratio: Formula, Interpretation, Examples, Tips to Improve it
2. Cash Ratio
Cash or cash-asset ratio is a financial ratio for analysis of a company’s capability to pay off short-term debt obligations with either cash or cash equivalents. This conservative liquidity ratio only considers a company’s liquid assets such as cash and cash equivalents.
Cash ratio = cash and cash equivalents/current liabilities
3. Current ratio
Current or Working capital ratio indicates the capability of the business to fulfil its short-term obligations due within one year. This financial ratio explains how companies can maximize the liquidity of their current assets to settle payables. It considers the weight of current assets versus current liabilities.
Current ratio = Current assets/current liabilities
4. Operating Cashflows
It measures how efficiently the company can pay off its current liabilities with the cash flow generated from business operations. It indicates how much a company earns from operational activities.
Operating cash flow ratio = Cash flow from operations/current liabilities
Must Read – Difference Between Sacrificing Ratio and Gaining Ratio
4. Profitability Ratios
Profitability ratios are the financial ratios for analysis of the company’s ability to generate profit relative to the following:
- Revenue
- Operating costs
- Balance sheet assets
- Shareholders’ equity during a specific time period
If the profitability ratio is high, the business is considered to be performing well, generating profits, revenue and cash flow. Following are the different types of profitability ratios:
- Gross margin ratio
- Return on assets ratio
- Operating Profit Margin
1. Gross Margin Ratio
The gross margin ratio is a ratio that compares the company’s gross margin to its margin. It indicates the amount of profit a company makes after paying the cost of goods sold (COGS).
Gross Margin Ratio = (Revenue – COGS) / Revenue
2. Return on Assets Ratio
It is a metric of investment that measures the business’s profitability by comparing net income to the capital invested in assets. The higher the return, the higher the productive and efficient management in economic resource utilization.
ROA = Net Income / Average Assets
or
ROA = Net Income / End of Period Assets
3. Operating Profit Margin
It is a performance ratio that reflects the profit percentage of the company that is produced from operations before reducing taxes and interest charges. This is also known as the (Earnings Before Interest and Tax) EBIT margin.
Operating profit margin = operating profit/ total revenue
Limitations of Financial Ratios
Some limitations of financial ratios include:
- They rely on historical data, which may not predict future performance.
- Ratios can be affected by accounting policies and practices, potentially leading to inconsistencies.
- These do not account for external factors such as market conditions or economic changes.
- Ratios provide quantitative analysis but do not capture qualitative aspects like management quality or company reputation.
FAQs
What is current ratio?
Current Ratio serves as a measure of a company's capability to meet its short-term obligations using its short-term assets.
What does current ratio indicate?
A ratio greater than 1 suggests that the company has more current assets as compared current liabilities, indicating good liquidity.
What does the Debt to Equity Ratio tell us?
The Debt to Equity Ratio assesses a company’s financial leverage and indicates that the proportion of debt used to finance the company's assets relative to equity. A higher ratio signifies higher leverage and potentially increased financial risk.
How can financial ratios be used in comparison?
Financial ratios are useful for comparing a company's performance over different periods (trend analysis) or against other companies within the same industry (benchmarking). This helps identify a company's strengths, weaknesses, and areas needing improvement.
What does the inventory turnover ratio tell us?
This ratio explains how quickly a company sells and replaces its inventory over a period. A higher ratio generally indicates better performance.
How can financial ratios be misinterpreted?
Ratios can be misinterpreted if not considered in context. Factors like industry norms, company size, and economic conditions should be taken into account.
What is the quick ratio (acid-test ratio)?
The is a more stringent measure of liquidity than the current ratio. It excludes inventory from current assets in its calculation.
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