3 Minutes! Financial Ratios & Financial Ratio Analysis Explained & Financial Statement Analysis
Importance of financial ratios
Consider several reasons financial ratios are important in business:
What is a financial ratio?
Using financial values, a financial ratio is a mathematical calculation that can shed light on a company’s profitability, effectiveness, competitive advantage, overall financial health, and market position. You can perform a quantitative analysis and assess your company’s liquidity, growth, leverage, return rates, profitability, and valuation through financial ratios by using the values contained in crucial financial statements, such as your balance sheet, income statement, and statement of cash flow for your organization. Additionally, each financial ratio you employ uses a particular calculation method, providing you with the resources required to assess the financial health of your company.
Types of financial ratios
The common financial ratios that companies and organizations use to gauge profitability, revenue effectiveness, and overall financial health are illustrated by the following examples:
Working capital ratio
The difference between your company’s current assets and current liabilities, as well as your ability to quickly pay off current liabilities with current cash assets, is what is known as working capital. The working capital ratio is calculated by deducting current liabilities from current assets. A ratio of 3:4 means that a company pays $750,000 in liabilities for every $1,000,000 in current assets it has, for example, if it has $1,000,000 in current assets and owes $750,000 in current liabilities.
The price-to-earnings ratio of your company compares the share price to the earnings per share shareholders receive. The formula price-to-earnings = (share price) / (earnings per share) can be used to determine the price-to-earning ratio. Applying these figures to the formula, for instance, if a business sells stock shares for $150 per share and makes $82 from each share sold, the price-to-earning ratio is as follows:
Price-to-earnings = ($150) / ($82) = 1. 83%. This proportion shows how much money your business makes for each share of stock it sells.
Acid-test or quick ratio
The quick ratio, also known as the acid-test ratio, is a financial ratio that assesses your company’s capacity to settle its short-term obligations with its liquid assets. You can determine how well your company manages its short-term liabilities by using the formula quick ratio = (current assets – inventory) / (current liabilities). Additionally, you can learn more about the value of the current assets that your business can easily liquidate by using the acid-test or quick ratio. Assume a company wants to calculate its quick ratio with $250,000 in current assets, $130,000 in inventory value, and $75,000 in current liabilities. It uses the formula and finds:
Quick ratio = ($250,000 – $130,000) / ($75,000) = 1. 6% or a rate of 1. 6 to 1.
Earnings per share ratio
The net income shareholders receive on each share of a company’s stock is measured by the earnings-per-share ratio, or EPS ratio. This ratio can help you gain understanding of your company’s capacity to produce stock earnings and distribute dividends to its major shareholders and stakeholders. Use the formula EPS = (net income or earnings) / (total value of outstanding shares) to determine the EPS ratio. For instance, a company might use the following formula to determine its EPS ratio with $500 per share of net income and 1,500,000 shares outstanding:
EPS is calculated as follows: (500 cents per share for 10,000 shares) / ($150,000) = ($5,000,000) / ($1,500,000) = 3 3 or a ratio of 3. 3 to 1. The business can anticipate profits rather than losses because the result is a positive value rather than a negative value.
The debt-to-equity ratio compares the total debt and financial liabilities of your company to the book value of its equity in shareholders. This calculation offers useful information about your company’s borrowing patterns and can help you determine whether it is taking on too much debt. A modest debt-to-equity ratio that can raise safety margins, lower fixed costs, and boost profits can be indicated if the value is between zero and one.
When a company’s total liabilities are $600,000 and its total shareholder equity is $950,000, you can determine its debt-to-equity ratio using the formula debt to equity = (total liabilities) / (total shareholder equity) and the example below:
Debt to equity = ($600,000) / ($950,000) = 0. 63, which shows that the example company’s debt-to-equity ratio is 0. 63 to 1. This value demonstrates that the company can pay dividends to its shareholders and has a manageable debt-to-equity ratio.
Gross profit margin
Because it reveals how much profit your company makes after deducting its cost of goods sold, the gross profit margin or gross margin ratio is a crucial financial metric to monitor. A company’s gross profit margin also demonstrates how much money it makes on each sale. Additionally, gross profit margins, which exclude overhead and indirect expenses like utilities and employee salaries, can reveal information about a company’s overall profitability. Assuming a business earns $1,250,000 in gross profits and generates $2,500,000 in total sales, determine the gross profit margin using the formula gross margin = (gross profit) / (total sales):
Gross profit margin = ($1,250,000) / ($2,500,000) = 0. 5 or 50%. This indicates an excellent gross margin ratio.
The asset turnover ratio reveals how well your business uses its assets to generate sales. To put it another way, the asset turnover rate compares the revenue of your company to the value of its assets. Consequently, the more assets your company turns over, the more effectively it can generate revenue. Applying the equation asset turnover = (net sales) / (the average total assets) will yield this financial ratio. Take your company’s hypothetical $450,000 net sales and average total assets of $350,000 as an example. You can determine the asset turnover ratio using the following formula:
Asset turnover = ($450,000) / ($350,000) = 1. 3. This is a ratio of 1. 3 to 1 or a 1. 3% asset turnover rate, which shows that your company is very effective at generating income from its assets.