In this lesson, you will learn about the types of financial ratios. Specifically, this lesson will cover the following:
1. Classification
Financial statements are generally insufficient to provide information to investors on their own; the numbers contained in these documents need to be put into context so that investors can better understand the different aspects of the company’s operations. Ratio analysis is one of three methods an investor can use to gain that understanding.
In the framework of business analysis and profitability, financial ratio analysis allows an observer to put the data provided by a company into context. This allows the observer to gauge the strength of different aspects of the company’s operations.
Financial statement analysis is the process of understanding the risk and profitability of a firm through an analysis of the reported financial information. Ratio analysis is a foundation for evaluating and pricing credit risk and for doing fundamental company valuation. A financial ratio, or accounting ratio, is derived from a company’s financial statements and is a calculation showing the relative magnitude of selected numerical values taken from those financial statements.
-
- Ratio Analysis
- The use of quantitative techniques on values taken from an enterprise’s financial statements.
2. Types of Ratios
There are various types of financial ratios that are grouped by their relevance to different aspects of a company’s business as well as to their appeal to different audiences. Financial ratios may be used internally by the managers within a firm, current and potential shareholders and creditors of a firm, and other audiences interested in understanding the strengths and weaknesses of a company, especially in the context of the company’s performance over time or compared to other companies.
Most analysts think of financial ratios as consisting of five basic types. Analyzing these ratios helps analysts and investors gain deeper insight into businesses’ financial positions. Each of these types of ratios have subsets of equations that measure the efficacy of a business. The categories and examples of some ratios in each category are as follows. You will learn more about each of these in subsequent lessons.
1. Profitability ratios: These measure the firm’s use of its assets and control of its expenses to generate an acceptable rate of return.
- Operating Margin = Operating Income/Revenue
- Gross Profit Margin = Gross Profit/Sales
- Net Profit Margin = Net Profit/Sales
- Return on Assets = Net Income/Total Assets
- Basic Earning Power = EBIT/Total Assets
- Return on Equity = Net Profit/Total Equity
2.
Liquidity ratios: These measure the availability of cash to pay debt.
- Current Ratio = Current Assets/Current Liabilities
- Quick Ratio = (Current Assets−Inventory)/Current Liabilities
3.
Asset management ratios: These measure the effectiveness of a firm’s use of resources or assets (also called efficiency ratios).
- Inventory Turnover Ratio = Cost of Goods Sold/Average Inventory
- Day Sales Outstanding Ratio = Accounts Receivable/Average Day Sales
- Fixed Assets Turnover Ratio = Total Sales/Average Fixed Assets
- Total Asset Turnover Ratio = Total Sales/Average Total Assets
4.
Debt, or leverage, ratios: These measure the firm’s ability to repay long-term debt.
- Debt Ratio = Total Liabilities/Total Assets
- Times Interest Earned Ratio = EBIT/Interest Expense
5.
Market ratios: These measure the cost of issuing stock and the relationship between the return and the value of an investment in a company’s shares; they are concerned with shareholder audiences.
- Price-to-Earnings Ratio = Price Per Share/Earnings Per Share
- Price-to-Book Ratio = Price Per Share/Book Value Per Share
-
If you are curious about these ratios, you can access any publicly traded company by visiting the
U.S. Security and Exchange Commission’s (SEC’s) EDGAR website to search for 10-K reports. A Form 10-K is an annual report required by the SEC that gives a comprehensive summary of a company’s financial performance.
Make sure to look for the “10-K (Annual Report)” in the list for the corporation you choose. There will be many years and variations in the search list. Scroll through the 10-K report until you find the financial statements. Now, you can use the appropriate information to calculate the financial ratios. You can also use online financial websites to find many of these ratios.
In this lesson, you learned that ratio analysis is classified as a tool that investors and managers use to better understand a company’s operations. Ratio analysis uses the information provided on a company’s financial statements. There are five basic types of ratios, including profitability, liquidity, asset management, debt, and market ratios.
Best of luck in your learning!
