Financial Ratio Analysis: Understanding Your Company’s Performance

 Financial ratios are the important tools for the businesses, investors, creditors, and analysts to make informed decisions and drive business success. These ratios provide valuable insights into company’s financial performance.

1. Liquidity Ratios

These ratios measure a company’s capability to pays its short-term debts. These ratios help investors and creditors determine whether a company can meet its immediate debts.

Current Ratio

This ratio evaluates the company’s ability to pay its short-term debts with its current assets. Generally, the accepted ratio is 2:1

It can be calculated as:

 current assets/current liabilities

Quick Ratio

This ratio evaluates the company’s ability to pay its short-term debts with its quick assets (most liquidated assets). Generally, the accepted ratio is 1:1

It can be calculated as:

current assets-inventory-prepaid assets/current liabilities

2. Efficiency Ratios

These rations measure the company’s capability to utilize its assets and resources efficiently. These ratios help investors and creditors determine whether a company is optimizing its operations to maximize profits.

Asset Turnover Ratio

This ratio evaluates how efficiently a company uses and manages its assets to generate sales. A higher ratio indicates more efficient use of assets.

It can be calculated as:

sales/total assets 

Inventory Ratio

This ratio evaluates how efficiently a company manages its inventory. A higher ratio indicates faster inventory turnover.

It can be calculated as:

cost of goods sold/average inventory 

Accounts Receivable Turnover Ratio

This ratio evaluates how efficiently a company collects its receivables. A higher ratio indicates faster collection of receivables.

It can be calculated as:

credit sales/average account receivables 

Accounts Payable Turnover Ratio

This ratio evaluates how efficiently a company pay its payables. A higher ratio indicates faster collection of payables.

It can be calculated as:

credit purchases/average account payables 

3. Solvency Ratios

These ratios measure a company’s capability to pay its long-term debts. These ratios help investors and creditors determine whether a company can meet its long-term financial obligation.

Debt-to-Equity Ratio

This ratio evaluates the proportion of debt to equity in a company’s capital structure. A higher ratio indicates higher debt levels and potential solvency issues.

It can be calculated as:

total debt/total shareholders' equity 

Debt-to-Asset Ratio

This ratio evaluates the proportion of debt to assets in a company’s capital structure. A higher ratio indicates higher debt levels and potential solvency issues.

It can be calculated as:

total debt/total asset 

Interest Coverage Ratio

This ratio evaluates company’s ability to pay its interest on its debt. A higher ratio indicates better ability to pay interest on debt.

It can be calculated as: 

earning before interest and tax/interest expense

Long-term Debt Ratio

This ratio evaluates the proportion of long-term debt to total assets. A higher ratio indicates higher debt levels and potential solvency issues.

It can be calculated as:

long-term debt/total asset 

4. Profitability Ratios

These ratios measure a company’s capability to generate profit. These ratios help investors and analysts determine whether a company is using its resources efficiently to generate earnings.

Gross Margin Ratio

This ratio evaluates the difference between revenue and cost of goods sold. A higher ratio means higher profitability.

It can be calculated as:

gross profit/sales 

Operating Profit Ratio

This ratio evaluates the profit generated from operations before interest and taxes. A higher ratio means higher profitability from operations.

It can be calculated as:

operating profit/sales 

Net Profit Margin

This ratio evaluates the net income generated by a company. A higher ratio means higher profitability.

It can be calculated as:

net income/sales 

Return on Equity

This ratio evaluates the return on shareholders’ equity. A higher ratio indicates higher return on equity.

It can be calculated as:

net income/shareholders' equity 

Return on Investment

This ratio evaluates how well a company generates profit from its capital. A higher ratio indicates higher return on investment.

It can be calculated as:

net income/total investment 

Return on Assets

This ratio evaluates the return on total assets. A higher ratio indicates higher return on assets.

It can be calculated as:

net income/total assets 

5. Market Ratios

These ratios measure a company’s stock performance and value. These ratios help investors determine whether a company’s stock is overvalued or undervalued relative to its earnings, book value, and dividend yield.

Price-to-Earnings (P/E) Ratio

This ratio evaluates relationship between a company’s stock price and its earnings. A higher P/E ratio indicates higher investor expectations for future growth.

It can be calculated as:

market price per share/earning per share 

Price-to-Book (P/B) Ratio

This ratio evaluates relationship between a company’s stock price and its book value. A higher P/B ratio indicates higher investor expectations for future growth.

It can be calculated as:

market price per share/book value per share

Dividend Yield Ratio

This ratio evaluates the return on investment for shareholders in the form of dividends. A higher ratio indicates higher returns for shareholders.

It can be calculated as:

annual dividend per share/market price per share

No doubt, financial ratios play crucial role in business success. As these ratios help the company to evaluate performance, make informed decisions, identify trends, monitor risks, and improves the financial management.