A ratio is a mathematical number calculated as a reference to relationship of two or more numbers and can be expressed as a fraction, proportion, percentage and a number of times. When the number is calculated by referring to two accounting numbers derived from the financial statements, then it is termed as financial or accounting ratios.
Financial ratio analysis is the process of calculating financial ratios, which are mathematical indicators calculated by comparing key financial information appearing in financial statements of a business, and analyzing those to find out reasons behind the business’s current financial position and its recent financial performance, and develop expectation about its future outlook.
These relationships between the financial statement accounts help investors, creditors, and internal company management understand how well a business is performing and of areas needing improvement.
Ratios can also be used to compare different companies in different industries. They allow us to compare companies across industries, big and small, to identify their strengths and weaknesses. Financial ratios are often divided up into seven main categories: liquidity, solvency, efficiency, profitability, market prospect, investment leverage, and coverage.
They are the most common and widespread tools used to analyze a business’ financial standing. Ratios are easy to understand and simple to compute. Accounting ratios exhibit relationship, if any, between accounting numbers extracted from financial statements.
There is a two way classification of ratios: (1) traditional classification, and (2) functional classification. The traditional classification has been on the basis of financial statements to which the determinants of ratios belong.
1. Statement of Profit and Loss Ratios: A ratio of two variables from the statement of profit and loss is known as statement of profit and loss ratio. For example, ratio of gross profit to revenue from operations is known as gross profit ratio. It is calculated using both figures from the statement of profit and loss.
2. Balance Sheet Ratios: In case both variables are from the balance sheet, it is classified as balance sheet ratios. E.g. ratio of current assets to current liabilities is known as current ratio. It is calculated using both figures from balance sheet.
3. Composite Ratios: If a ratio is computed with one variable from the statement of profit and loss and another variable from the balance sheet, it is called composite ratio. For example, ratio of credit revenue from operations to trade receivables (known as trade receivables turnover ratio) is calculated using one figure from the statement of profit and loss (credit revenue from operations) and another figure (trade receivables) from the balance sheet.
However, the traditional method is hardly followed now-a-days and the entities use the functional method which is as follows:
Liquidity ratios asses a business’s liquidity, i.e. its ability to convert its assets to cash and pay off its obligations without any significant difficulty (i.e. delay or loss of value). Liquidity ratios are particularly useful for suppliers, employees, banks, etc. Important liquidity ratios are:
1. Current ratio: Evaluates the ability of a company to pay short-term obligations using current assets (cash, marketable securities, current receivables, inventory, and prepayments).
Current Ratio = Current Assets ÷ Current Liabilities
2. Quick ratio (also called acid-test ratio): It measures the ability of a company to pay short-term obligations using the more liquid types of current assets or "quick assets" (cash, marketable securities, and current receivables).
Acid Test Ratio = Quick Assets ÷ Current Liabilities
3. Cash ratio: Measures the ability of a company to pay its current liabilities using cash and marketable securities. Marketable securities are short-term debt instruments that are as good as cash.
Cash Ratio = (Cash + Marketable Securities) ÷ Current Liabilities
Solvency ratios assess the long-term financial viability of a business i.e. its ability to pay off its long-term obligations such as bank loans, bonds payable, etc. Information about solvency is critical for banks, employees, owners, bond holders, institutional investors, government, etc. Key solvency ratios are:
1. Debt ratio: Measures the portion of company assets that is financed by debt (obligations to third parties).
Debt Ratio = Total Liabilities ÷ Total Assets
2. Debt to equity ratio: Evaluates the capital structure of a company. A D/E ratio of more than 1 implies that the company is a leveraged firm; less than 1 implies that it is a conservative one.
Debt-Equity Ratio = Total Liabilities ÷ Total Equity
3. Equity ratio: Determines the portion of total assets provided by equity (i.e. owners' contributions and the company's accumulated profits). Equity ratio can also be computed using the formula: 1 minus Debt Ratio.
Equity Ratio = Total Equity ÷ Total Assets
4. Times interest earned ratio: Measures the number of times interest expense is converted to income, and if the company can pay its interest expense using the profits generated. EBIT is earnings before interest and taxes.
Times Interest Earned = EBIT ÷ Interest Expense
5.Equity multiplier: The reciprocal of equity ratio is known as equity multiplier, which is equal to total assets divided by total equity.
Profitability ratios measure the ability of a business to earn profit for its owners. While liquidity ratios and solvency ratios explain the financial position of a business, profitability ratios and efficiency ratios communicate the financial performance of a business. Important profitability ratios include:
1. Net profit margin : Evaluates how much net gross profit is generated from sales. Net profit is Gross Profit less indirect expenses add indirect incomes.
Net Profit Rate = Net Profit ÷ Net Sales
2. Gross profit margin: Evaluates how much gross profit is generated from sales. Gross profit is equal to net sales (sales minus sales returns, discounts, and allowances) minus cost of sales.
Gross Profit Rate = Gross Profit ÷ Net Sales
3.Return on Sales: Also known as "net profit margin" or "net profit rate", it measures the percentage of income derived from dollar sales. Generally, the higher the ROS the better.
Return on Sales = Net Income ÷ Net Sales
4. Return on equity: Measures the percentage of income derived for every dollar of owners' equity.
Return on Stockholders' Equity = Net Income ÷ Average Stockholders' Equity
5.Return on assets: It is the measure of the return on investment. ROA is used in evaluating management's efficiency in using assets to generate income.
Return on Assets = Net Income ÷ Average Total Assets
Other ratios related to profitability that are used by investors to assess the stock market performance of a business. These ratios are also known as ‘Growth Ratios’ which include:
1.Earnings per share: EPS shows the rate of earnings per share of common stock. Preferred dividend is deducted from net income to get the earnings available to common stockholders.
EPS = (Net Income - Preferred Dividends) ÷ Average Common Shares Outstanding
2. Price to earnings (P/E) ratio: Used to evaluate if a stock is over- or under-priced. A relatively low P/E ratio could indicate that the company is under-priced. Conversely, investors expect high growth rate from companies with high P/E ratio.
Price-Earnings Ratio = Market Price per Share ÷ Earnings per Share
3.Dividend payout ratio: Determines the portion of net income that is distributed to owners. Not all income is distributed since a significant portion is retained for the next year's operations.
Dividend Pay-out Ratio = Dividend per Share ÷ Earnings per Share
4. Dividend yield ratio: Measures the percentage of return through dividends when compared to the price paid for the stock. A high yield is attractive to investors who are after dividends rather than long-term capital appreciation.
Dividend Yield Ratio = Dividend per Share ÷ Market Price per Share
5. Retention ratio: The retention ratio refers to the percentage of net income that is retained to grow the business, rather than being paid out as dividends. It is the opposite of the payout ratio, which measures the percentage of earnings paid out to shareholders as dividends.
Conceptually, it is the opposite of payout ratio.
Retention Ratio = 1 − Dividend Payout Ratio = Retained Earnings / Net Income.
Activity ratios assess the efficiency of operations of a business. For example, these ratios attempt to find out how effectively the business is converting inventories into sales and sales into cash, or how it is utilizing its fixed assets and working capital, etc. These are sometimes also called ‘Management Efficiency ratios’. Key activity ratios are:
1. Inventory turnover ratio: Represents the number of times inventory is sold and replaced. Take note that some authors use Sales in lieu of Cost of Sales in the above formula. A high ratio indicates that the company is efficient in managing its inventories.
Inventory Turnover = Cost of Sales ÷ Average Inventory
2. Days inventory outstanding: Also known as "inventory turnover in days". It represents the number of days inventory sits in the warehouse. In other words, it measures the number of days from purchase of inventory to the sale of the same. Like DSO, the shorter the DIO the better.
Days Inventory Outstanding = 360 Days ÷ Inventory Turnover
3. Receivables turnover ratio: Measures the efficiency of extending credit and collecting the same. It indicates the average number of times in a year a company collects its open accounts. A high ratio implies efficient credit and collection process.
Receivable Turnover = Net Credit Sales ÷ Average Accounts Receivable
4. Days sales outstanding: Also known as "receivable turnover in days", "collection period". It measures the average number of days it takes a company to collect a receivable. The shorter the DSO, the better. Take note that some use 365 days instead of 360.
Days Sales Outstanding = 360 Days ÷ Receivable Turnover
5. Payables turnover ratio: Represents the number of times a company pays its accounts payable during a period. A low ratio is favored because it is better to delay payments as much as possible so that the money can be used for more productive purposes.
Accounts Payable Turnover = Net Credit Purchases ÷ Ave. Accounts Payable
6. Days payable outstanding: Also known as "accounts payable turnover in days", "payment period". It measures the average number of days spent before paying obligations to suppliers. Unlike DSO and DIO, the longer the DPO the better (as explained above).
Days Payable Outstanding = 360 Days ÷ Accounts Payable Turnover
7. Total asset turnover ratio: Measures overall efficiency of a company in generating sales using its assets. The formula is similar to ROA, except that net sales is used instead of net income.
Total Asset Turnover = Net Sales ÷ Average Total Assets
8.Cash conversion Cycle: CCC measures how fast a company converts cash into more cash. It represents the number of days a company pays for purchases, sells them, and collects the amount due. Generally, like operating cycle, the shorter the CCC the better.
Cash Conversion Cycle = Operating Cycle - Days Payable Outstanding
Coverage ratios are supplementary to solvency and liquidity ratios and measure the risk inherent in lending to the business in long-term. They include EBIDTA coverage ratio, debt coverage ratio, interest coverage ratio (also known as times interest earned), fixed charge coverage ratio, etc.