Financial Ratios

Financial ratios are the best tools to analyze the performance of a company. There are so many ratios which helps a lot in understanding the issues and find out solutions to resolve the problems. Ratios can alone tell a complete story of the issues and problems inside the company and attract management actions and strategies to make good any worst situation.

Usually, financial ratios are calculated over the periods to compare various periods’ performance. So, one can easily identify the gray areas which need strategic level management attention. Auditors often take the support of various ratios to examine the records and make observations for any wrong thing going inside the client’s operation. They include such point in the letter of recommendation with suggesting ways to overcome the underlying causes.

A very interesting thing which financial ratios are popular to demonstrate is that you can compare competitors within the industry to analyze the performance of your chosen company. As we know that in an industry, various sizes of companies exist with small and big setups. We cannot compare these companies because the level of investment and setup they have. In such a scenario, the role of ratios comes into existence.  By calculating the financial ratios of various size companies in the industry, you can compare them and make your decision accordingly where you stand. Investors take a lot of help from these tools.

On a broad scale, we can divide the financial ratios as follows:

Solvency Ratios

These ratios are used to assess the long term performance of the company. This is; whether it will be able to meet its long term loans and obligations payments in the long term. 

Liquidity Ratios

As the name suggests, these types of ratios are used to assess the short term performance of the company. Financial institutions, banks and suppliers give a lot of importance to the following liquidity ratios to judge its criteria for granting the loan:

  • Current ratio
  • Acid test or quick ratio
  • Cash ratio
  • Cash conversion cycle

Activity ratios

These ratios are used to analyze the performance of the operations of the business. Most common activity ratios are:

  • Inventory turnover ratio
  • Days sales in inventory
  • Debtor’s turnover or receivables turnover ratio
  • Days sales outstanding
  • Payables turnover or Creditors turnover ratio
  • Days payable outstanding
  • Fixed asset turnover ratio
  • Working capital turnover ratio

Profitability ratios

These ratios involve profit figure into consideration with other factors to assess the profitability of the business. Various profitability ratios are:

  • Net profit margin
  • Gross profit margin
  • Operating profit margin
  • Return on assets (ROA)
  • ROCE (Return on capital employed)
  • Return on equity (ROE)
  • Earnings per share (EPS)
  • Price to earnings ratio (PE)
  • Dividend payout (DP) ratio
  • Dividend yield (DY) ratio
  • Retention ratio