Financial ratio offers a way to evaluate a company’s performance and compare it to similar companies. Understanding the ways to apply financial ratios to determine the success of an organization is an important element of finance management.
What is Financial Ratio?
It is a calculation where financial values are determined to get an insight into the overall financial health of a company and its market position. The value thus obtained can be used in the balance sheet, statement of cash flows, and other important financial statements. Each financial ratio needs a unique formula for its calculation, which leaves you with the tools necessary for your business evaluation.
Still wondering what is a financial ratio? Let’s move ahead to understand more about it.
Types of financial Ratio
1. Liquidity ratios – Liquidity ratios are one of the types of financial ratios that enable a company to determine its ability to pay its short and long-term obligations. The common liquidity ratios are:
- Current ratio – It is used to measure the ability of a company to pay its short-term liabilities using its current assets.
- Acid-test ratio – It is used to measure the ability of a company to pay its short-term liability using the assets that can be liquidated easily. Acid-test ratio gives insight into the value of the current assets that an organization can easily liquidate.
- Cash ratio – It measures the ability of an organization to pay its short-term liability using cash and equivalents.
- Operating cash flow ratio – It is a measure to find the number of times an organization can pay off its liability with the generated cash in a given duration.
2. Leverage ratio – Another type of financial ratio is the leverage ratio used to calculate a company’s debt levels.
Common leverage ratios are:
- Debt ratio – It is the total debt of an organization to its total assets, and it is expressed in percentages. If the value is more than 1, an organization’s debt has more liabilities than assets.
- Debt to equity ratio – It is a financial ratio that evaluates a company’s financial leverage by dividing its liabilities by shareholder equity. It tells you the borrowing patterns of your company and if your company is borrowing too much. If the value is between zero and one, we can say that the company has safe margins.
- Interest coverage ratio – It measures how easily a company can pay off the interest on its outstanding debts. It is calculated by dividing the earnings of a business before taxes and interest by its interest expense in a given time.
3. Efficiency ratio – The efficiency ratio is another type of financial ratio that tells how well a company uses its resources and assets. Some common efficiency ratios are:
- Asset-turnover ratio – measures the company’s ability to generate sales from its assets. Its value is directly proportional to a company’s efficiency.
- Inventory turnover ratio – measures the number of times an organization’s inventory is sold over time.
- Days sales inventory ratio – calculates the number of days that a company can hold on before selling its inventory to customers.
4. Profitability ratio – Another type of financial ratio is a profitability ratio used to determine the company’s ability to generate income in terms of revenue, its operating costs, equity and balance sheet assets. Common profitability financial ratios are:
- Gross margin ratio – is an important financial metric that showcases the profit made by an organization after deducting the cost of sold goods. It measures the earnings of a company in each sale.
- Operating margin ratio – measures how efficiently a company is generating revenue using its assets.
- Return on equity ratio – calculates how efficiently a company is generating revenue using its equity.
5. Market value ratio – The market value ratio is a financial ratio that is used to determine the share price of a company’s stock.
Uses of Financial Ratio
Knowing what financial ratio is not enough, as you should also understand how to implement it in a business for your benefit. Calculating financial ratios helps a business in two ways:
- Enables a company to track its performance –Financial ratio helps a company in tracking its value over time. It helps in determining the trends developing in a company. Its importance can be understood by taking an example of a financial ratio – debt to asset ratio. A high debt-to-asset ratio may show a company that is overburdened by debt and may face default risk in the future.
- Allows a company to make a comparative judgment regarding its performance – Financial ratios help a company determine its performance in terms of the industry average.
A great way to skill up in financial ratio is ot enrol in a reputed finance management course.
Finance Management Course
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