Comprehensive Guide to Financial Ratios: From Definitions to Practical Applications

 Financial Ratios

Ratio Analysis is a technique of financial statement analysis. It is widely used tool to interpret quantitative relationship between two variables of financial statement. Ratio is arithmetical expression of relationship between two interdependent items. 

Accounting ratio is ratio when calculated on the basis of accounting information. (accounting variables).

Ratio analysis is one of the oldest methods of financial statements analysis. It was developed by banks and other lenders to help them chose amongst competing companies asking for their credit. Two sets of financial statements can be difficult to compare. The effect of time, of being in different industries and having different styles of conducting business can make it almost impossible to come up with a conclusion as to which company is a better investment. 

Ratio analysis helps creditors solve these issues. Here is how:

What are Financial Ratios?

1. Shortcut: Financial ratios provide a sort of heuristic or thumb rule that investors can apply to understand the true financial position of a company. There are recommended values that specific ratios must fall within. Whereas in other cases, the values for comparison are derived from other companies or the same companies own previous records. However, instead of undertaking a complete tedious analysis, financial ratios help investors shortlist companies that meet their criteria.
2. Sneak-Peek: Investors have limited data to make their decisions with. They do not know what the state of affairs of the company truly is. The financial statements provide the window for them to look at the internal operations of the company. Financial ratios make financial analysis simpler. They also help investors compare the relationships between various income statement and balance sheet items, providing them with a sneak peek of what truly is happening behind the scenes in the company.
3. Connecting the Dots: Over the years investors have realized that financial ratios have incredible power in revealing the true state of affairs of a company. Analyses like the DuPont Analysis have brought to the forefront the inter-relationship between ratios and how they help a company become more profitable.

Definition & Purpose of Financial Ratios

Financial ratios are quantitative measures derived from a company's financial statements. They simplify complex data into actionable insights, helping to evaluate performance and risk.

Why They Matter

These ratios are crucial tools for investors, creditors, and management alike. They provide a standardized way to compare companies, track performance over time, and identify potential issues or strengths.

Sources of Data 

Here is where the investors get the data they require for ratio analysis:

1. Financial Statements: The financial data published by the company and its competitors is the prime source of information for ratio analysis.
2. Best Practices Reports: There are a wide range of consulting firms that collate and publish data about various companies. This data is used for operational benchmarking and can also be used for financial data analysis.
3. Market: The data generated by all the activity on the stock exchange is also important from ratio analysis point of view. There is a whole class of ratios where the stock price is compared with earnings, cash flow and such other metrics to check if it is fairly priced.

Types of Financial Ratio

1. LIQUIDITY & SOLVENCY RATIOS:

1. Current Ratio: Current ratio is a ratio between current assets and liabilities, which tells that for every dollar in current liabilities, how many current assets do the company possess. Since the current liabilities are usually paid out of current assets, it makes sense to compare the two figures to assess the liquidity of the firm. Liquidity implies the ease with which the current liabilities can be paid off. Generally, the higher the ratio, the better it is considered, but too high a ratio may imply less productive use of current assets. A ratio of two to one (2:1) is considered ideal. Current Ratio = Current Assets / Current Liabilities
2. Quick/Acid Test ratio: Quick ratio is relatively a stringent measure of liquidity. The ratio is obtained by subtracting inventory from current assets and dividing the result by current liabilities. Inventory is the least liquid of all current assets. By subtracting inventory from current assets, we are actually comparing more liquid assets with current liabilities. This ratio not only helps in gauging the solvency of the company, it may also show if the inventories are piling up. A desirable quick ratio can range from (0.8:1) to (1.5:1) depending on the nature of the business. Quick/Acid Test ratio = (Current Assets – Inventory) / Current Liabilities
3. Average Collection Period: Also known as Days Sales Outstanding, average collection period shows in how many days the Accounts receivables of the company are converted into cash. Most of the companies sell most of their products/services on credit basis, hence it is critical for the company to know in how much time these receivables could be converted to cash in order to ensure liquidity at all Times Average collection period is calculated using the following formula. Average Collection Period = Average Accounts Receivable / (Annual Sales/360)

Note: Average collection period is usually expressed in terms of days. If you find a decimalized answer, you should round it off to the next integer.

2. PROFITABILITY RATIOS:

The profitability ratios show the combine effects of liquidity, asset management, and debt management on operating result.

1. Profit Margin (on sales): One of the most commonly used ratios is profit margin on sales. This ratio tells the percentage of profit for every dollar of revenue earned. This ratio is usually expressed in terms of percentage and the general rule is , the higher the ratio, the better it is. Most of the companies compare this ratio to the previous years’ ratios to assess if the company is better off.  Profit Margin (on sales): = [Net Income / Sales] X 100
2. Return on Assets: Return on assets is another profitability ratio, which shows the profitability of the company against each dollar invested in total assets. We can obtain this figure by simply by dividing the net profit with total assets. Since the assets are economic resources that are used to earn profit, it is logical to assess if the assets have been used efficiently enough to generate profits. This ratio is also expressed in percentage terms.  Return on Assets = [Net Income / Total Assets] X 100
3. Return on equity: Return on equity is of special interest to the shareholders, since equity represents the owners’ share in the business. Return on equity can be obtained by dividing the net income with the total equity. This ratio shows that for each dollar in equity how much profit is generated by the company.  Return on equity = [Net Income/Common Equity]

3. ASSET MANAGEMENT RATIOS

These measures show how effectively the firm has been managing its assets.

1. Inventory Turnover: Inventory turnover shows the number of times the inventories are replenished within one accounting cycle. The ratio can be obtained by dividing the sales by inventory. While the quick ratio measures the liquidity and points out the inventory piling problem, the inventory turnover confirms whether or not the major portion of the current assets of the firm are tied up in inventory. This ratio is also used in measuring the operating cycle and cash cycle of the firm. A higher turnover is desirable as it reflects the liquidity of the inventories.  Inventory Turnover = Sales / inventories
2. Total Assets Turnover: An effective use of total assets held by a company ensures greater revenue to the firm. In order to measure how effectively a company has used its total assets to generate revenues, we compute the total assets turnover ratios, dividing the sales by total assets.  Total Assets Turnover = Sales / Total Assets

An increasing ratio over the years may show that with an addition of assets, the company has been able to generate incremental sales in greater proportion.

4. DEBT (OR CAPITAL STRUCTURE) RATIOS:

1. Debt-Assets: A commonly used ratio to measure the capital structure of the firm is debt to assets ratio. Capital structure refers to the financing mix (proportion of debt and equity) of a firm. The greater the proportion of debt in the financing mix, the less willing creditors, and investors would be to provide more finances to the company. In India, the debt to assets ratio is prescribed in prudential regulations by the State Bank of India as a guideline for the banks (creditors). A ratio greater than 0.66 to 1 is considered alarming for the providers of funds.  Debt-Assets = Total Debt / Total Assets
2. Debt-Equity: Another commonly used ratio, debt to equity, explicitly shows the proportion to debt to equity. A ratio of 60 to 40 is used for new projects, i.e., for a project it is permitted to raise its finances 60 percent from the debt and 40 percent from equity. Debt to equity is computed by the following formula.  Debt-Equity = Total Debt / Total Equity
3. Times-Interest-Earned: Times-interest-earned reflects the ability of a company to pay its financial charges (interest). This ratio is obtained by dividing the operating profit by the interest charges. Conceptually, the interest charges are to be paid from the earnings before interest and taxes. A ratio of 4 to 1 show that the company covers the interest charges 4 times, which is generally considered satisfactory by the management, however, a ratio higher than that, may be more desirable. A high time interest- earned ratio is a good sign, especially for the creditors.  Times-Interest-Earned = EBIT / Interest Charges
4. Market Value Ratios: Market value ratios relate the firm’s stock price to its earnings & book value per share. These ratios give management an indication of what equity investors think of the company’s past performance & future prospects
5. Price Earnings Ratio: It shows how much investors are willing to pay per rupee of reported profits. This ratio reflects the optimism, or lack thereof, investors have about the future performance of the company.  Price Earnings Ratio = Market Price per share / *Earnings per share
6. Market /Book Ratio: Market to book ratio gives an indication how equity investors regard the company’s value. This ratio is also used in case of mergers, acquisition or in the event of bankruptcy of the firm. = Market Price per share / Book Value per share Earnings Per Share (EPS) = Net Income / Average Number of Common Shares Outstanding

Top 20 Financial Ratios with Benchmarks

Ratio	Formula	Benchmark
1) Gross Profit Margin	(Revenue - COGS) / Revenue	20% - 40% (varies by industry)
2) Operating Margin	Operating Income / Revenue	10% - 20%
3) Net Profit Margin	Net Income / Revenue	5% - 15%
4) Return on Assets (ROA)	Net Income / Total Assets	5% or higher
5) Return on Equity (ROE)	Net Income / Shareholder's Equity	10% - 20%
6) Return on Capital Employed (ROCE)	EBIT / Capital Employed	15% or higher
7) Current Ratio	Current Assets / Current Liabilities	1.5 - 3.0
8) Quick Ratio (Acid Test)	(Current Assets - Inventory) / Current Liabilities	1.0 or higher
9) Cash Ratio	Cash & Equivalents / Current Liabilities	0.5 - 1.0
10) Inventory Turnover	COGS / Average Inventory	5 - 10 times/year
11) Receivables Turnover	Net Credit Sales / Avg. Accounts Receivable	6 - 12 times/year
12) Asset Turnover	Revenue / Total Assets	0.5 - 2.0
13) Days Sales Outstanding (DSO)	365 / Receivables Turnover	30 - 60 days
14) Days Inventory Outstanding (DIO)	365 / Inventory Turnover	30 - 90 days
15) Debt-to-Equity Ratio	Total Debt / Shareholders’ Equity	1.0 - 2.0
16) Debt Ratio	Total Liabilities / Total Assets	0.3 - 0.6
17) Interest Coverage Ratio	EBIT / Interest Expense	3.0 or higher
18) Financial Leverage Ratio	Total Assets / Equity	1.5 - 3.0
19) Earnings Per Share (EPS)	Net Income / Outstanding Shares	Higher is better
20) Price-to-Earnings (P/E)	Market Price per Share / EPS	15 - 25

Advantages of Ratio Analysis

1. Useful in the Analysis of Financial Statements - Ratios helps in interpreting and understanding complex financial statements. They convert raw figures into meaningful data which is enabling better evaluation of profitability, liquidity, solvency, and efficiency.
2. Useful in Simplifying Accounting Data - Bigger accounting numbers become easier to understand when expressed through ratios. It represents the data in a concise and comparable form, making it easier for users to draw conclusions.
3. Useful in Assessing the Operating Efficiency of Business - Ratios helps to evaluate how efficiently a business is using its resources such as inventory, assets, and working capital. They are also revealing strengths and weaknesses in operational performance.
4. Useful for Forecasting and Planning - By analyzing and comparing the past and present ratios, businesses can estimate future trends. This helps management in planning budgets, setting goals, and making financial decisions.
5. Useful in Locating Weak Areas - Poor ratios highlight the problematic areas such as low profitability, poor asset utilization, or liquidity issues. This enables management to take corrective actions in time.
6. Useful in Inter-firm and Intra-firm Comparison - Ratios enable comparison:
• Inter firm - Between different firms to evaluate competitiveness with industry standards.
• Intra firm - Within the same firm over multiple years to assess performance trends and growth.

Limitations of Ratio Analysis

1. Possibility of False or Misleading Results - Ratios are calculated using accounting data which may be manipulated or affected by errors. If financial statements are inaccurate, the ratios based on them will also be misleading.
2. Qualitative Factors are Ignored - Ratios analyze only numerical financial data and it ignore non-financial elements such as employee skills, management quality, brand value, customer satisfaction, and market conditions all of which affect performance.
3. Lack of Standard or Universal Ratio - There is no fixed standard for many ratios it varies. What is considered a “good” ratio for one firm or industry may not be acceptable for another, limiting their usefulness for comparison.
4. May Not Be Comparable - Ratios of different firms may not be comparable due to differences in accounting policies, methods of valuation, size of business, or seasonal influences.
5. Effect of Price Level Changes - Financial statements are usually prepared based on historical cost basis. Inflation or deflation can distort asset values and profits, leading to inaccurate ratios over time.
6. Subject to Personal Bias - Interpretation of ratios depends on the judgment of the financial analyst. Different people may draw different conclusions from the same set of ratios, leading to subjective results.

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