Financial Ratios Definition and Types with Examples and Formulas

Financial ratios are a way to measure a company's financial health and performance by comparing various financial metrics. They help investors, analysts, and business owners make informed decisions.

There are two main types of financial ratios: liquidity ratios and profitability ratios. Liquidity ratios measure a company's ability to pay its short-term debts, while profitability ratios evaluate its ability to generate earnings.

Liquidity ratios include the current ratio, which is calculated by dividing current assets by current liabilities. For example, if a company has $100,000 in current assets and $50,000 in current liabilities, its current ratio is 2:1. This means the company can pay its short-term debts twice over.

Profitability ratios, on the other hand, include the gross margin ratio, which is calculated by dividing gross profit by sales. For instance, if a company has a gross profit of $50,000 and sales of $100,000, its gross margin ratio is 50%. This indicates that for every dollar sold, the company earns 50 cents in profit.

Financial ratios are a way to express the relationship between two pieces of numerical data, typically taken from a company's financial statements. They provide valuable insights into a company's inner workings, helping you understand its valuation, revenues, and profitability.

Financial ratios can be used to compare two companies, which is especially useful when considering investments. For example, evaluating two companies in the tech sector with share prices of $10 and $55, respectively, can be misleading if you don't understand what's driving share prices or how the market values each company.

Financial ratios are mathematical calculations used to analyze a company's financial statements and provide insights into performance by comparing values over time and against industry benchmarks. This helps identify strengths, weaknesses, and competitive positioning.

The main categories of financial ratios are liquidity ratios, solvency ratios, efficiency ratios, profitability ratios, and valuation ratios, which evaluate different aspects of a company's financial health.

Earnings Per Share (EPS) measures a company's net income allocated to each share of common stock outstanding. It represents profitability attributable to shareholders on a per-share basis.

A higher EPS indicates greater profitability per share held. This means that investors can expect a higher return on their investment. For instance, if a company has an EPS of Rs.2, it suggests that each share of stock is generating Rs.2 in profit.

EPS is calculated by dividing the company's net income minus preferred dividends by the average outstanding shares. This formula provides insight into the profit generated for each share of stock.

The EPS formula is a simple yet powerful tool that helps you understand a company's profitability. EPS = Net profit / Number of common shares.

To find net profit, you'd subtract total expenses from total revenue.

Net profit is also referred to as net income by investors.

This formula is used to calculate a company's Earnings Per Share, which is a key metric for investors.

Earnings per Share (EPS) is a crucial metric that helps investors understand a company's profitability. It's calculated by dividing the company's net income by the number of outstanding shares.

A higher EPS indicates greater profitability per share held. This is because it shows that each shareholder is receiving a larger portion of the company's profits.

For example, if a company has a net income of $2 million and 12,000,000 shares outstanding, its EPS works out to $0.166. This means that each shareholder is receiving $0.166 in profit for each share held.

EPS gives investors a clear picture of a company's financial health. It's a key metric to consider when evaluating a company's performance.

To calculate earnings per share, you need to know the net profit and the number of common shares. The EPS formula is Net profit divided by Number of common shares.

Net profit is found by subtracting total expenses from total revenue, and investors often refer to it as net income. This is a straightforward calculation, but it's essential to get it right.

The net profit is then used in the EPS formula. To get the current earnings per share, you'll need to know the current stock price and the EPS. The P/E formula is Current stock price divided by Current earnings per share.

The debt-to-equity ratio can also give you insight into a company's financial health. A lower debt-to-equity ratio is generally considered better, as it means the company has fewer debt obligations.

The current ratio is another important metric that can help you understand a company's liquidity. It's calculated by dividing Current Assets by Current Liabilities.

In a real-world example, a potential investor might consider a company's financial health and performance before making a decision.

The investor would look at the company's financial statements and calculate financial ratios such as the debt-to-equity ratio. A lower debt-to-equity ratio is generally better, as it means the company has fewer debt obligations.

For instance, a company with $5 million in debt and $10 million in shareholder equity would have a debt-to-equity ratio of 0.5. This ratio can help the investor understand the company's leverage.

The investor would also consider the company's return on equity ratio, which can indicate the company's profitability. A higher return on equity ratio is generally better, as it means the company is generating more profit from its shareholders' equity.

In a real-world example, a company might be considering acquiring a competitor and wants to evaluate the financial performance of both companies. They would look at the financial statements of both companies and calculate financial ratios such as the price-to-earnings ratio.

For example, if a company's stock is trading at $50 per share and its EPS for the past 12 months averaged $5, the price-to-earnings ratio would be 10. This ratio can help the company compare the financial performance of the two companies.

By analyzing these financial ratios, the investor or company can make an informed decision on whether to invest in the company or proceed with the acquisition.

Coverage is a critical aspect of a company's financial health, and it's closely tied to Earnings Per Share (EPS). A company's ability to cover its expenses and debt obligations is essential for its sustainability and growth.

Lenders use coverage ratios to determine a business's ability to pay back borrowed money. These ratios measure how well a company manages its obligations to suppliers, creditors, and others.

The Debt Service Coverage Ratio (DSCR) reflects a company's ability to pay all its debts, including interest and principal, at any given time. A DSCR above 1 means the company has more than enough money to meet its debt servicing needs.

A company's ability to cover its interest expenses is also crucial. The Interest Coverage Ratio (ICR) measures how easily a company pays interest expenses on outstanding debt. A higher ICR indicates a greater cushion for paying interest costs.

Asset coverage ratio measures risk by determining how much of a company's assets would need to be sold to cover its debts. A ratio of 1 or higher suggests the company has sufficient assets to cover its debts.

A company's dividend payments are also subject to coverage ratios. The Dividend Cover measures how many times a company could pay its dividend from its net income over a period. A higher coverage ratio indicates dividends are more affordable for the company.

The price-to-earnings (P/E) ratio is a fundamental financial metric that helps investors evaluate a company's stock price relative to its earnings per share. It's a simple yet powerful tool that can reveal whether a stock is undervalued or overvalued.

A high P/E ratio suggests that investors expect a company to experience significant growth in the future, and are willing to pay a premium for its stock. Conversely, a low P/E ratio may indicate that a stock is undervalued and presents a buying opportunity.

To calculate the P/E ratio, you simply divide the current stock price by the current earnings per share. For example, if a stock is trading at $50 per share and its EPS is $5, the P/E ratio would be 10, meaning investors are willing to pay $10 for every dollar generated in annual earnings.

The P/E formula is a simple yet powerful tool that helps investors determine the value of a stock. It's calculated by dividing the current stock price by the current earnings per share.

To get the P/E ratio, you need to know the current stock price and the current earnings per share. The P/E formula is P/E = Current stock price / Current earnings per share.

This formula is a key part of understanding the P/E ratio, which is a crucial metric for investors.

The price-to-earnings ratio is a simple yet powerful tool for investors to gauge a company's stock price. It's calculated by dividing the current stock price by the current earnings per share.

A P/E ratio of 10, like in the example of a company trading at $50 per share with an EPS of $5, suggests investors are willing to pay $10 for every dollar generated in annual earnings. This ratio can give you a sense of how expensive a stock is compared to its competitors.

A high P/E ratio, such as 10, indicates potential overvaluation, while a low P/E ratio, like in the example of a company with a P/E ratio of 2, implies an undervalued stock. This is because investors are willing to pay more for a stock with higher expected growth prospects.

The P/E ratio formula is straightforward: P/E = Current stock price / Current earnings per share. For instance, if a stock is trading at Rs.50 per share and its EPS is Rs.5, the P/E ratio is 10, meaning investors are paying Rs.10 for every Rs.1 of earnings.

A company's P/E ratio can also indicate its growth prospects. For example, a company with a $250,000 gross margin and $2 million in net sales has a gross margin ratio of 12.5%, which means it realizes a smaller profit percentage per sale.

Equity is a company's book value, which represents assets minus liabilities. This is calculated by subtracting total liabilities from shareholders' equity.

A company's debt-to-equity ratio is a key indicator of its financial health, with a lower ratio generally being better as it means fewer debt obligations. This ratio is calculated using the D/E formula: D/E = Total liabilities / Shareholders equity.

For example, a company with $5 million in debt and $10 million in shareholder equity would have a debt-to-equity ratio of 0.5.

Equity and Leverage are two financial concepts that are closely related. Equity refers to the ownership interest in a company, while leverage refers to the use of debt to finance assets. A company's equity ratio can tell you how much of the company is owned by investors and how much of it is leveraged by debt.

The debt-to-equity ratio measures the relationship between a company's total liabilities and shareholders' equity. A higher ratio indicates greater long-term solvency risk, while a lower ratio suggests less leverage and more financial stability. For example, if a company has Rs.2 million in total liabilities and Rs.3 million in shareholders' equity, its debt-to-equity ratio is 0.67.

A company's debt-to-equity ratio can be calculated using the formula: Total liabilities / Shareholders' equity. This ratio is useful for analyzing the capital structure and assessing a firm's ability to pay off long-term debts.

The debt-to-asset ratio measures the proportion of a company's assets that are financed through debt. A higher ratio indicates greater financial leverage and risk, while a lower ratio suggests less leverage. For instance, if a company has Rs.500,000 in total debt and Rs.2,000,000 in total assets, its debt-to-asset ratio is 0.25.

Debt service coverage ratio is another important leverage ratio that measures a company's ability to repay debt obligations from operating income. A higher ratio indicates a greater ability to service debts from operations. For example, if a company has Rs.1 million in net operating income and Rs.500,000 in total debt service payments, its debt service coverage ratio is 2.

Interest coverage is a crucial aspect of a company's financial health, and it's calculated by dividing EBIT by interest expenses.

Lenders use interest coverage ratios to determine a business's ability to pay back borrowed money.

A higher interest coverage ratio indicates a greater cushion for paying interest costs, while a lower ratio suggests the company has trouble meeting interest obligations.

For instance, if a company has $100,000 in EBIT and $25,000 in annual interest expense, its interest coverage ratio is 4, meaning it has four times more earnings than interest payments.

A company with Rs.500,000 in EBIT and Rs.100,000 in interest expenses has an interest coverage ratio of 5, indicating it has five times more EBIT than needed to cover its interest obligations.

A company's asset coverage ratio is a measure of its financial stability, and it's calculated by dividing the difference between its total assets and intangible assets by its total debt. This ratio can give you an idea of how well a company can cover its debts.

A ratio of 1 or higher suggests the company has sufficient assets to cover its debts, while a ratio below 1 means it doesn't have enough assets to cover its debts. This is similar to the debt service coverage ratio.

You can find all the information you need to calculate this ratio on a company's balance sheet.

The price to book value ratio is a crucial metric for investors to assess the value of a company's stock. It compares a company's market value to its book value, which represents the company's assets minus liabilities.

A lower price to book value ratio indicates a stock is undervalued, while a higher ratio suggests it is potentially overvalued. For instance, if a company has a market capitalization of Rs.5 billion and its book value is Rs.2 billion, its price to book value ratio is 2.5.

This ratio provides a way to gauge whether a stock is undervalued or overvalued relative to its accounting value. The price to book ratio is calculated by dividing the market price per share by the book value per share.

A P/B ratio below 1 suggests the stock is undervalued relative to its asset value on the balance sheet. For example, if a stock is trading at Rs.20 per share and has a book value of Rs.10 per share, its P/B ratio is 2.

This means investors value the company at 2 times its book value, which might be considered a premium. The price to book value ratio is an essential tool for investors to evaluate a company's stock and make informed investment decisions.

Return is a financial ratio that measures a company's ability to generate profits from shareholder equity. It's calculated using the ROE formula.

The ROE formula is straightforward: ROE = Net income – Preferred dividends / Value of average common equity. This formula helps us understand how efficiently a company is using its shareholder equity to generate profits.

Using the ROE example, a company with net income of $2 million and preferred dividends of $200,000 will have a ROE of 0.18 or 18% if its total common equity value is $10 million. This means the company is generating a decent profit from its shareholder equity.

A higher ROE generally indicates that a company is generating more profits from its shareholder equity, which is a good sign for investors.

Liquidity and Solvency are two essential concepts in finance that help you understand a company's financial health. Liquidity ratios measure a company's ability to pay its debts and other liabilities, indicating its cash flow strength.

A current ratio above 1 indicates a company has more assets than liabilities, a comforting sign of financial health. However, a ratio too high might suggest that you're not using your assets efficiently.

Solvency ratios, on the other hand, measure a company's ability to pay its debts over the long term. The debt-to-equity ratio compares total liabilities to shareholder equity, with a lower ratio suggesting a company is using less debt to finance its operations.

For small businesses, liquidity is about survival and flexibility. High liquidity ratios mean you can cover your bills and obligations without strain, giving you the freedom to seize opportunities or weather downturns.

Liquidity is a crucial aspect of a company's financial health, and it's essential to understand the different liquidity ratios that can help you assess a company's ability to pay its debts and other liabilities.

A company's liquidity is its ability to convert its assets into cash quickly, and liquidity ratios can give you an idea of how easily a company can do this. Liquidity ratios can be especially important for newer companies, which may face more significant cash flow challenges compared to established companies.

The Current Ratio is a simple yet effective liquidity ratio that measures a company's ability to pay its current liabilities with its current assets. It's calculated by dividing a company's total current assets by its total current liabilities. A Current Ratio above 1 indicates a company has more assets than liabilities, which is a comforting sign of financial health.

The Quick Ratio, also known as the Acid-Test Ratio, is another important liquidity ratio that measures a company's ability to use its most liquid assets to pay off its current liabilities. It's calculated by dividing a company's cash, cash equivalents, and short-term investments by its current liabilities. A Quick Ratio of 1 or higher indicates good short-term financial strength.

A company's ability to pay its short-term debts with cash is also an essential aspect of its liquidity. The Cash Ratio measures a company's capacity to pay off its short-term debt obligations with only cash and cash equivalents. It's calculated by dividing a company's cash and cash equivalents by its current liabilities. A higher Cash Ratio indicates a stronger ability to cover short-term obligations.

For example, a company with $100,000 in cash and $500,000 in current liabilities would have a Cash Ratio of 0.2, which means it has enough cash on hand to pay 20% of its current liabilities. This suggests that the company may struggle to meet its short-term debt obligations without taking on more debt or diluting shares.

In contrast, a company with $30,000 in cash, $10,000 in marketable securities, and $30,000 in current liabilities would have a Cash Ratio of 1, which means it has enough cash on hand to pay its short-term debt obligations. This suggests that the company has a strong ability to cover its short-term debt obligations with its most liquid assets.

Overall, liquidity ratios can provide valuable insights into a company's financial health and ability to pay its debts and other liabilities. By understanding these ratios, you can make more informed investment decisions and assess a company's ability to weather financial challenges.

Solvency is a crucial aspect of a company's financial health, and it's essential to understand what it means and how to measure it. Solvency ratios measure a company's ability to meet its long-term financial obligations, indicating the adequacy of its cash flow to pay debts and other obligations.

The debt-to-equity ratio is a key financial ratio used to measure solvency, comparing total liabilities to shareholder equity. A lower ratio suggests a company is using less debt to finance its operations, which is generally seen as positive.

Interest coverage ratio is another important solvency ratio, indicating how easily a business can pay interest on outstanding debt with its earnings before interest and taxes (EBIT). A higher ratio shows that a business can comfortably cover its interest payments, a good sign of financial health.

A debt ratio of less than 1 indicates that a majority of assets are financed through equity, which is preferable. Solvency ratios, such as the Debt to Equity Ratio and Interest Coverage Ratio, are pivotal for small business owners, helping them manage debt responsibly and signal financial health to potential investors.

The debt service coverage ratio compares earnings to total debt payment obligations, providing insight into a company's ability to meet its long-term financial obligations. A ratio of 1 or higher suggests a company has sufficient assets to cover its debts, while a ratio below 1 means the company doesn't have enough assets to cover its debts.

Service coverage is crucial for any business, as it measures a company's ability to meet its long-term financial obligations. This includes paying debts and other obligations.

A debt service coverage ratio is used to determine a company's ability to repay debt obligations from operating income. It compares net operating income to total debt service payments.

A higher debt service coverage ratio indicates a greater ability to service debts from operations. A lower ratio suggests potential difficulty meeting obligations.

For example, a company with Rs.1 million in net operating income and Rs.500,000 in total debt service payments has a debt service coverage ratio of 2, indicating it has two times more operating income than needed to cover its debt payments.

The debt service coverage ratio can be calculated by dividing net operating income by total debt service. A ratio above 1 means the company has more than enough money to meet its debt servicing needs.

A company's debt service coverage ratio can be tracked over time to provide insight into improving or worsening debt repayment capacity. Comparing industry benchmarks also provides a useful perspective.

A debt service coverage ratio of 2 means the company has twice the operating income needed to cover its debt payments. This is a good sign, indicating the company has a strong ability to meet its debt obligations.

The net profit margin is a crucial metric that helps assess a company's profitability and operational efficiency. It measures how much net income a company generates per dollar of revenue.

For example, if a company has Rs.10 million in revenue and Rs.2 million in net income, its net profit margin is 20%. This means the company converted 20% of its revenue into net profits.

A higher net profit margin indicates a company's ability to retain a larger portion of its revenue after accounting for production and selling costs. In the example given, for every Rs.1 in revenue, the company retains Rs.0.20 after deducting expenses.

The net profit margin ratio is calculated by dividing net income by revenue and multiplying by 100. So, if a company has Rs.5 million in net income and Rs.25 million in revenue, its net profit margin would be (5/25) x 100 = 20%.

A company with a higher net profit margin is generally considered more financially stable and efficient in its operations.

Average Days to Collect is a key metric that measures how quickly a company can collect payment on its credit sales. It's a crucial indicator of a company's cash flow strength.

A lower Average Days to Collect indicates greater efficiency in collecting accounts receivable. This is because it shows that the company is able to collect payments quickly, reducing the risk of late payments. For example, XYZ Company takes roughly 73 days on average to collect payment on credit sales.

The formula to calculate Average Days to Collect is DSO = Accounts Receivable / (Net Credit Sales / 365). This means that if a company has Rs.1 million in accounts receivable and Rs.5 million in net credit sales, its DSO would be 73 days, just like XYZ Company.

Companies aim to optimize their Average Days to Collect to ensure the timely collection of receivables. A lower DSO shows that the company is able to manage its credit and collection policies effectively.