Financial Ratio Definition:
The financial ratio or financial indicators are coefficients or reasons that provide financial and accounting units of measurement and comparison, through which, the ratio (division) together two data direct financial, allow analyzing the state current or past an organization to function at optimum levels defined for it.
The Financial Ratios are comparable with those of the competition and lead to analysis and reflection of the performance of companies against their rivals, then the fundamentals of application and explained the calculation of each.
History of Financial Ratio Analysis:
Analysis Financial Ratio, Indices, Reasons or ratios, was one of the first tools developed of Financial Analysis.
In the early nineteenth century, the use by analysts of financial statements became apparent, especially, the use of current ratio and liquidity ratio. During the twentieth century, there was a standardization of the set of indexes that were created. To this end, optimal for each financial ratio levels were created, regardless of whether the entity or organization to analyze was the state of the economy of a country or a company in particular.
Because of their diversity in the organizations, the current use of these reasons can or should be standardized, because, every non – company or entity has optimal that identify, depending on the activity carried out, the periods used, etc.
Objective of Financial Ratio Analysis:
The objective of the analysis of financial statements is to simplify the figures and their relationships and make possible comparisons to facilitate their interpretation.
By interpretation, it is meant to give meaning to the financial statements and determine the causes of facts, unfavorable and favorable trends surveyed by analysis of the financial statements so that the negative effects for business can be avoided.
4 Types of Financial Ratios:
The ratio analysis is the starting point for developing the information, which can be classified into 4 groups as follows:
Liquidity Ratios: It measures the ability to pay short – term debts of the Company to settle the obligations coming due.
Activity Ratios: It measures the effectiveness with which the company is using the Active employees.
Profitability Ratios: It measures the ability of the company to generate profits.
Coverage Ratios: It measures the degree of protection to creditors and long – term investor. Within this group in our country, the most used is the ratio between liabilities and total assets or equity to total assets.
Types of Financial Ratios and their Formulas:
Below are the key list of the classification and interpretation of various different types of financial ratio’s along with their formulas.
Liquidity Ratio Definition:
An organization’s liquidity is evaluated by the ability to repay short – term obligations that have been acquired as they become due. Refer not only to total the finance of the company but its ability to make cash certain assets and liabilities. Liquidity ratio is one of the type of financial ratio.
Net Working Capital (NWC): This ratio is obtained by deducting the current liabilities of the company all rights currents.
Net Working Capital Formula |
Net Working Capital Ratio = Current Assets – Current Liabilities |
Solvency Index: This considers the true extent of the company at any point in time and is comparable with different entities of the same activity.
Solvency Index Formula |
Solvency Index Ratio = Current Assets / Current liabilities |
Acid Test Ratio / Quick Ratio: This test is similar to the solvency ratio, but under current assets is not taken into account the inventory of products, since this is less liquid assets.
Acid Test Formula |
Acid Test Ratio = (Active current – Inventory) / Current liabilities |
Inventory Turnover: This is used to measure the liquidity of inventory through their movement during the period.
Inventory Turnover Formula |
Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory |
Average Inventory Ratio / Average Age of Inventory: Represents the average number of days an item stays in the inventory of the company.
Average Inventory Formula |
Average Inventory Ratio = 365 / Inventory turnover |
Debtor’s Turnover Ratio or Receivable Turnover Ratio: It measures the liquidity of accounts receivable through its rotation.
Receivable Turnover Formula |
Receivable Turnover Ratio = Sales Year to Credit / Average Accounts Receivable |
Average Term Receivables / Average Collection Period: It is a reason that indicates the evaluation of the policy of credit and collections of the company.
Average Collection Period Formula |
Average Collection Period Ratio = 365 / Accounts Receivable Turnover |
Rotation Accounts Payable Ratio is used to calculate the number of times accounts payable become effective during the year.
Rotation Accounts Payable Formula |
Rotation Accounts Payable Ratio = Purchases Annual Credit / Average Accounts Payable |
Average Term Payable Ratio: Allows glimpse the rules of payment of the company.
Average Term Payable Formula |
Average Term Payable Ratio = 365 / Rotation Accounts Payable |
Debt Ratio Definition:
These reasons indicate the amount of money from third parties that are used to generate profits, these are very important because these debts committed to the company over time. Debt ratio measures the proportion of total assets contributed by company’s creditors. Debt ratio is one of the another types of financial ratio.
Debt Ratio Formula |
Debt Ratio Ratio = Total Liabilities / Total Assets |
Reason Passive Capital Ratio: Indicates the relationship between those who provide business owners and long – term funds to provide creditors.
Reason Passive Capital Formula |
Reason Passive Capital Ratio = Long-Term Liabilities / Stockholders Equity |
Total Debt to Capitalization Ratio: It has the same objective of the above reason, but also serves to determine the long – term funds percentage to provide creditors, including long – term debt as equity.
Total Debt to Capitalization Formula |
Total Debt to Capitalization Ratio = Long Term Debt / Total Capitalization |
The analysis of financial ratios is one of the ways of measuring and assessing the operation of the company and the management of its managers.
Profitability Ratio Definition:
These reasons to analyze and evaluate the earnings of the company with respect to a given sales level asset or investment of the owners. Profitability ratio is one of the crucial financial ratio for fundamental analysis to either buy or sell the stocks.
Gross Profit Margin Ratio: Indicates the percentage of sales remaining after the company has paid its stocks.
Gross Profit Margin Formula |
Gross Profit Margin Ratio = (Sales – Cost of Goods Sold) / Sales |
Operating Profit Margin Ratio: Represents the net profits the company earns on the value of each sale. These must be taken into account by deducting financial or governmental charges and determines only the company’s operation.
Net profit margin Ratio: Determines the percentage remaining in each sale after deducting all expenses as well as taxes.
Total Asset Turnover Ratio: Indicates the efficiency with which the company can use its assets to generate sales.
Total Asset Turnover Formula |
Total Asset Turnover Ratio = Annual Sales / Total Assets |
Return on Investment Ratio: Determines the administration’s overall effectiveness to make a profit with the available assets.
Return on Investment Formula |
Return on Investment Ratio = Net profits after taxes / Total Assets |
Performance Common Capital Ratio: Indicates the margin get over value in books of stockholders’ equity.
Common Capital Formula |
Common Capital Ratio = (Net Profits after Tax – Preferred Dividends) / Stockholders Equity – Preferred Capital |
Cost Utility Ratio: Represents the total winnings obtained for each existing common share.
Cost Utility Formula |
Cost Utility Ratio = Earnings Available from Ordinary Shares / Number of Ordinary Shares Outstanding |
Dividends Per Share Ratio: This represents the amount paid to each shareholder at the end of the period of operations.
Dividends Per Share Formula |
Dividends Per Share Ratio = Dividends Paid / Number of Outstanding Shares |
Coverage Ratio Definition:
These reasons evaluate the ability of the company to cover certain fixed charges. These are more often associated with fixed charges are for the debts of the company. Coverage ratio is one of the priority calculation in evaluating financial ratio.
Times Interest Earned Ratio: Calculate the capacity of the company to make contractual interest payments.
Times Interest Earned Formula |
Times Interest Earned Ratio = Earnings before Interest and Taxes / Annual Interest Expenditure |
Total liabilities Coverage Ratio: This ratio considers the ability of the company to meet its obligations for interest and the ability to repay the principal of loans or credits to make funds amortization.
Total Liabilities Coverage Formula |
Total Liabilities Coverage Ratio = Earnings before Interest and Taxes / Interest to the Principal Liability |
Total Coverage Ratio: This ratio includes all types of obligations, both fixed and temporary, determines the ability of the company to cover all financial charges.
Total Coverage Formula |
Total Coverage Ratio = (Earnings before Lease Payments, Interest and Taxes) / (Interest + Payments to the Principal Lease Payments Liabilities) |
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Basics of Fundamental Analysis for Beginners
- Chapter 1: What is Fundamental Analysis? Definition, Types, Examples
- Chapter 2: Characteristics and Mindset of a Great Investor
- Chapter 3: How to Analyze and Read the Annual Report of a Company?
- Chapter 4: Qualitative Factors in Investment Decisions of Company Analysis
- Chapter 5: What is Qualitative Data Analysis? Methods to Measure Performance
- Chapter 6: What is Cash Flow Statement? Definition, Example, Format, Analysis
- Currently Reading: Financial Ratio Definition, Examples, Ratio Analysis Interpretation
- Chapter 8: What is Investment Due Diligence? Examples, Process, Procedure
- Chapter 9: What is Discounted Cash Flow? Analysis, Examples, Problems
- Chapter 10: What is Equity Research? Definition, Examples, Report Analysis
- Chapter 11: Basics of Fundamental Analysis Quiz - Questions and Answers