What Is Financial Ratio Analysis?

Overview, Definition, and Calculation of Financial Ratios

Small business owner doing finances
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Getty Images/Trevor Williams 

Financial ratio analysis uses the data contained in financial documents like the balance sheet and statement of cash flows to assess a business's financial strength. These financial ratios help business owners and average investors assess profitability, solvency, efficiency, coverage, market value, and more.

Key Takeaways

  • Financial ratio analysis assesses the performance of the firm's financial functions of liquidity, asset management, solvency, and profitability.
  • Financial ratio analysis is a powerful analytical tool that can give the business firm a complete picture of its financial performance on both a trend and an industry basis.
  • The information gleaned from a firm's financial statements by ratio analysis is useful for financial managers, competitors, and average investors.
  • Financial ratio analysis is only useful if data is compared to past performance or to other companies in the same industry.

What Is Financial Ratio Analysis?

Financial ratios are useful tools that help business managers, owners, and potential investors analyze and compare financial health. They are one tool that makes financial analysis possible across a firm's history, an industry, or a business sector.

Financial ratio analysis uses the data gathered from these ratios to make decisions about improving a firm's profitability, solvency, and liquidity.

Types of Financial Ratios

There are six categories of financial ratios that business managers normally use in their analysis. Within these six categories are multiple financial ratios that help a business manager and outside investors analyze the financial health of the firm.

It's important to note that financial ratios are only meaningful in comparison to other ratios for different time periods within the firm. They can also be used for comparison to the same ratios in other industries, for other similar firms, or for the business sector.

Liquidity Ratios

The liquidity ratios answer the question of whether a business firm can meet its current debt obligations with its current assets. There are three major liquidity ratios that business managers look at:

  • Working capital ratio: This ratio is also called the current ratio (current assets - current liabilities). These figures are taken off the firm's balance sheet. It measures whether the business can pay its short-term debt obligations with its current assets.
  • Quick ratio: This ratio is also called the acid test ratio (current assets - inventory/current liabilities). These figures come from the balance sheet. The quick ratio measures whether the firm can meet its short-term debt obligations without selling any inventory.
  • Cash ratio: This liquidity ratio (cash + cash equivalents/current liabilities) gives analysts a more conservative view of the firm's liquidity since it uses only cash and cash equivalents, such as short-term marketable securities, in the numerator. It indicates the ability of the firm to pay off all its current liabilities without liquidating any other assets.

Efficiency Ratios

Efficiency ratios, also called asset management ratios or activity ratios, are used to determine how efficiently the business firm is using its assets to generate sales and maximize profit or shareholder wealth. They measure how efficient the firm's operations are internally and in the short term. The four most commonly used efficiency ratios calculated from information from the balance sheet and income statement are:

  • Inventory turnover ratio: This ratio (sales/inventory) measures how quickly inventory is sold and restocked or turned over each year. The inventory turnover ratio allows the financial manager to determine if the firm is stocking out of inventory or holding obsolete inventory.
  • Days sales outstanding: Also called the average collection period (accounts receivable/average sales per day), this ratio allows financial managers to evaluate the efficiency with which the firm is collecting its outstanding credit accounts.
  • Fixed assets turnover ratio: This ratio (sales/net fixed assets) focuses on the firm's plant, property, and equipment, or its fixed assets, and assesses how efficiently the firm uses those assets.
  • Total assets turnover ratio: The total assets turnover ratio (sales/total assets) rolls the evidence of the firm's efficient use of its asset base into one ratio. It allows analysts to gauge how efficiently the asset base is generating sales and profitability.

Solvency Ratios

A business firm's solvency, or debt management, ratios allow the analyst to appraise the position of the business firm's debt financing or financial leverage that they use to finance their operations. The solvency ratios gauge how much debt financing the firm uses as compared to either its retained earnings or equity financing. There are two major solvency ratios:

  • Total debt ratio: The total debt ratio (total liabilities/total assets) measures the percentage of funds for the firm's operations obtained by a combination of current liabilities plus its long-term debt.
  • Debt-to-equity ratio: This ratio (total liabilities/total assets - total liabilities) is most important if the business is publicly traded. The information from this ratio is essentially the same as from the total debt ratio, but it presents the information in a form that investors can more readily utilize when analyzing the business.

Coverage Ratios

The coverage ratios measure the extent to which a business firm can cover its debt obligations and meet the associated costs. Those obligations include interest expenses, lease payments, and, sometimes, dividend payments. These ratios work with the solvency ratios to give a financial manager a full picture of the firm's debt position. Here are the two major coverage ratios:

  • Times interest earned ratio: This ratio (earnings before interest and taxes (EBIT)/interest expense) measures how well a business can service its total debt or cover its interest payments on debt.
  • Debt service coverage ratio: The DSCR (net operating income/total debt service charges) is a valuable summary ratio that allows the firm to get an idea of how well the firm can cover all of its debt service obligations.

Profitability Ratios

Profitability ratios are the summary ratios for the business firm. When profitability ratios are calculated, they sum up the effects of liquidity management, asset management, and debt management on the firm. The four most common and important profitability ratios are:

  • Net profit margin: This ratio (net income/sales) shows the profit per dollar of sales for the business firm.
  • Return on total assets (ROA): The ROA ratio (net income/sales) indicates how efficiently every dollar of total assets generates profit.
  • Basic earning power (BEP): BEP (EBIT/total assets) is similar to the ROA ratio because it measures the efficiency of assets in generating sales. However, the BEP ratio makes the measurement free of the influence of taxes and debt.
  • Return on equity (ROE): This ratio (net income/common equity) indicates how much money shareholders make on their investment in the business firm. The ROE ratio is most important for publicly traded firms.

Market Value Ratios

Market Value Ratios are usually calculated for publicly held firms and are not widely used for very small businesses. Some small businesses are, however, traded publicly. There are three primary market value ratios:

  • Earnings per share (EPS): As the name implies, this measurement conveys the business's earnings on a per-share basis. It is calculated by dividing the net income by the outstanding shares of common stock.
  • Price/earnings ratio (P/E): The P/E ratio (stock price per share/earnings per share) shows how much investors are willing to pay for the stock of the business firm per dollar of profits.
  • Price/cash flow ratio: A business firm's value is dependent on its free cash flows. The price/cash flow ratio (stock price/cash flow per share) assesses how well the business generates cash flow.
  • Market/book ratio: This ratio (stock price/book value per share) gives the analyst another indicator of how investors view the value of the business firm.
  • Dividend yield: The dividend yield divides a company's annual dividend payments by its stock price to help investors estimate their passive income. Dividends are typically paid quarterly, and each payment can be annualized to update the dividend yield throughout the year.
  • Dividend payout ratio: The dividend payout ratio is similar to the dividend yield, but it's relative to the company's earnings rather than the stock price. To calculate this ratio, divide the dollar amount of dividends paid to investors by the company's net income.

How Does Financial Ratio Analysis Work?

Financial ratio analysis is used to extract information from the firm's financial statements that can't be evaluated simply from examining those statements. Ratios are generally calculated for either a quarter or a year.

To calculate financial ratios, an analyst gathers the firm's balance sheet, income statement, and statement of cash flows, along with stock price information if the firm is publicly traded. Usually, this information is downloaded to a spreadsheet program.

Small businesses can set up their spreadsheet to automatically calculate each of these financial ratios.

Interpretation of Financial Ratio Analysis

One ratio calculation doesn't offer much information on its own. Financial ratios are only valuable if there is a basis of comparison for them. Each ratio should be compared to past periods of data for the business. The ratios can also be compared to data from other companies in the industry.

It is only after comparing the financial ratios to other time periods and to the companies' ratios in the industry that an analyst can draw conclusions about the firm performance.

For example, if a firm's debt-to-asset ratio for one time period is 50%, that doesn't tell a useful story unless it's compared to previous periods, especially if the debt-to-asset ratio was much lower or higher historically. In this scenario, the debt-to-asset ratio shows that 50% of the firm's assets are financed by debt. The financial manager or an investor wouldn't know if that is good or bad unless they compare it to the same ratio from previous company history or to the firm's competitors.

Performing an accurate financial ratio analysis and comparison helps companies gain insight into their financial position so that they can make necessary financial adjustments to enhance their financial performance.

There are other financial analysis techniques that owners and potential investors can combine with financial ratios to add to the insights gained. These include analyses such as common size analysis and a more in-depth analysis of the statement of cash flows.

Who Uses Financial Ratio Analysis?

Several stakeholders might need to use financial ratio analysis:

  • Financial managers: Financial managers must have the information that financial ratio analysis imparts about the performance of the various financial functions of the business firm. Ratio analysis is a valuable and powerful financial analysis tool.
  • Competitors: Other business firms find the information about the other firms in their industry important for their own competitive strategy.
  • Investors: Current and potential investors (whether publicly traded or financed by venture capital) need the financial information gleaned from ratio analysis to determine whether or not they want to invest in the business.

Frequently Asked Questions (FAQs)

What are 5 key financial ratios?

Five of the most important financial ratios for new investors include the price-to-earnings ratio, the current ratio, return on equity, the inventory turnover ratio, and the operating margin.

Why is financial ratio analysis important?

Financial ratio analysis quickly gives you insight into a company's financial health. Rather than having to look at raw revenue and expense data, owners and potential investors can simply look up financial ratios that summarize the information they want to learn.

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