What are Financial Ratios?

What are Financial Ratios?

Monetary or Financial ratios compare different line items inside the financial statements for you to yield insights into the condition and results of a business. These ratios are in most cases employed by individuals outside a business since employees routinely have more detailed information available to them. Nonetheless, top managers need to be conversant with the final results of their key financial ratios, for them to discuss the rates with members of the investment community, creditors, and lenders.

Financial ratios can often compare companies within the industry since they commonly have approximately the same operating models in addition to using roughly the same proportions of assets with regards to their sales level. The result might be differences in current market valuation, as shareholders reward those businesses showing clearly much better ratio results as compared to their competitors. The reverse could also occur, where adverse economic ratios can trigger enough shareholder pressure on how the board of directors may feel compelled to terminate the actual employment of the CEO.

Financial ratios are typically divided into the following classifications:

Performance ratios – These ratios evaluate information on the income statement and are deliberate to judge the capability of an institute to generate a profit. Frequently used ratios in this categorization include:

  • Gross margin ratio. The formula is the gross margin, divided by sales.
  • Operating income ratio. The formula is operating income, divided by sales.
  • Net profit ratio. The formula is net profit, divided by sales.

Liquidity ratios – These ratios are used to approximate the capability of an institute to pay its bills, and are suspiciously watched by creditors and lenders. Frequently used ratios in this categorization include:

  • Days sales outstanding. The method is accounts receivable divided by annual sales, which is then multiplied by the number of days in the year.
  • Current ratio. The method is current assets, divided by current liabilities.
  • Quick ratio. The method is current assets not including inventory, divided by current liabilities.

Cash flow ratios – These ratios strip away any misleading effects caused by the growth basis of accounting to reveal the extent to which a business is generating cash. Frequently used ratios in this categorization include:

  • Cash flow return on assets. The method is net profit plus non-cash expenses, divided by total assets.
  • Cash flow from operations ratio. The method is cash flow from operations, divided by net income.
  • Cash reinvestment ratio. The method is the increase in the gross amount of fixed assets plus or minus changes in working capital, divided by the aggregation of net income and non-cash expenses.

Return on investment ratios – These ratios disclose the amount of return earned by investors when they invest in a business. Generally used ratios in this categorization include:

  • Return on equity. The method is net income, divided by stockholders’ equity.
  • Return on assets. The method is net income, divided by total assets.

There are important limitations on the use of financial ratios, which are as follows:

  • The information used for a ratio is as of a definite point in time or reporting period, which may not be analytical of long-term trends.
  • The information in a ratio is greatly aggregated and tells little about the underlying dynamics of a business.
  • The information reported in a ratio will vary, depending on the accounting policies of a business.