Financial ratios in simple words are the ratios which are used to estimate the efficiency of business operations, solvency of business, company’s liquidity and profitability. These ratios provide insights regarding various aspects of the business which helps the analysts and the investors about the investment prospects and the risk associated with investing in the business. Periodic review of financial ratios is essential to monitor financial health and performance of any business which makes analysis of these ratios a must have skill for business owners.
We will discuss each aspect in which various financial ratios are calculated and analysed. Majorly financial ratios are categorized under liquidity ratios, profitability ratios, solvency ratios, efficiency ratios, and market value ratios.
Liquidity Ratios
Liquidity ratio in simple words is ratio of liquid assets to the current liabilities, if we look carefully at the ratio, we are comparing liquid assets to current liabilities and hence this metric basically tells the about the ability of a company to pay its current liabilities like short- term debt. The preferred value of liquidity ratio is above 1 as it has assets as numerator and liabilities as denominator.
There are three major ratios which are covered under the liquidity ratio which are current ratio, quick ratio and cash ratio.
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Current Ratio:
Formula: Current ratio = Current Assets / Current Liabilities
Significance: In simple words current ratio is a ratio of current assets to current liabilities. So, if a company has current assets of greater value than current liabilities it has current ratio greater than 1 and if it has current assets of value lesser than current liabilities than the ratio is smaller than one. A value greater than one for the current ratio means that the company can easily pay off current debt obligations using its current assets.
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Quick Ratio (Acid-Test Ratio):
Formula: Quick ratio = (Cash + Accounts Receivables + Marketable Securities) / Current Liabilities.
Significance: As the name suggests this ratio is called as quick ratio as it only covers the assets that can be quickly converted to cash to cover the current liabilities of a company. It is a much robust test of a company’s ability to take care of its current liabilities as it considers only the assets that can be converted to cash in a short period of time like cash, accounts receivables, and marketable securities. Hence it is also referred to as the true test of a company’s liquidity.
Profitability Ratios
Profitability ratios as the name suggests are the ratios which tells about the profitability which can be understood as the ability of a company to generate profit with respect to revenue, balance sheet, costs of running operations, and stakeholder’s equity for a specific time. These ratios help in estimating how well an organisation is using its assets to generate profits and value for the shareholders.
To gain an edge every business needs to how well they are performing compared to competitors in the domain and how much the business has improved in comparison to the past performance reports.
Profitability ratios are of two types which are Margin ratios and Return ratios. These ratios monitor profitability at the cost level of measurement or in terms of returns provided to shareholders.
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Gross Profit Margin:
Formula: Gross Profit Margin = (Revenue – Cost of Goods Sold) / Revenue
Significance: From the formula mentioned above it can be understood as the ratio of revenue that exceeds the costs of goods sold. In simple words it compares revenue with the gross profit. Increasing gross margin can indicate that the company can charge some premium for its goods or services. Decreasing gross margin however indicates the increasing competition in the domain.
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Operating Margin
Formula: Operating Margin = Operating Income/ Revenue
Significance: Operating margin in simple words is the ratio of operating income to revenue. Operating income here refers to the money left from sales after taking our costs of goods sold and operating expenses. It is an amazing indicator of the managing operations. A company with good operating margin is usually able to absorb damage in profits due to slow economy.
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Pretax Margin
Formula: Pretax Margin = Earnings Before Tax/ Revenue
Significance: From the formula mentioned above we can analyse that the Pre tax margin is the ratio of earnings before tax and revenue. It quantifies how much profit a company generates before paying the taxes to the government. It reflects the impact of management decisions as pretax margin is about the before taking out taxes.
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Net Profit Margin:
Formula: Net Profit Margin = Net Profit / Revenue
Significance: This metric is basically used to estimate net profitability of a company as it deals with the profit after taking out every expense and taxes from the revenue. From the formula mentioned above we can observe that it is the ratio of profit to revenue for a given time period. It gives the estimate that how much profit a company makes after generating a particular revenue value.
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Return Ratios:
Return ratios in simple words are the ratios used to compare total income with the assets, equity, and invested capital for a business as this comparison provides insights regarding the efficiency of a company to convert the invested capital into profit for shareholders. Return ratios are directly correlated with the capability of a business to manage investments. The capability of a business to generate returns efficiently for shareholders and investors which is quantified with return ratios drives investors and shareholders to invest capital in the business.
Return on Assets (ROA): Formula: Return on Assets = Net Profit / Total Assets
Significance: Return on assets in simple words is the efficiency of utilization of assets to generate the profit observed in a given time. It is calculated to estimate how well a company can use its assets to generate returns for its shareholders.
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Return on Equity (ROE):
Formula: Return on Equity = Net Profit / Shareholder’s Equity
Significance: This is an important metric for the shareholders as it quantifies profit earned against the shareholder’s equity. High return on equity is a good sign for investors as it indicates that the company is able to generate cash and do not have rely on debt to generate profits.
Understanding financial ratios not only helps in managing finances related to business efficiently but also provides insights regarding operations, sales, business strategy, and reputation among shareholders. Smart investors go through these numbers before making investment decisions as financial ratios describe the overall condition of a business and provide an estimate of risk associated with investing in the business.
