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Financial Ratios: Uses & Categories

financial ratios

If you’re familiar with the fundamental analysis, you might know that financial ratios have a critical role to analyze stock.

Financial ratios express one quantity in relation to another. Like total debt and total assets, it will become a debt to asset ratio. Ratios quantities are taken by a company’s financial statements.

They are useful in selecting investments and predicting financial downward. Investors often use financial ratios to derive the values of companies

It is important to understand that financial ratios only tell computed ratios. And computed ratios aren’t the answer. The ratio is an indicator. It tells you what happened but not why it happened.

Uses of Financial Ratios

  1. Financial ratio analysis help analyst evaluate past performance.
  2. You can assess the current financial position of a company.
  3. A company’s financial ability to meet its short-term and long-term debt.
  4. Compare with peer companies or industries.
  5. Check management’s ability.

Categories Of Financial Ratios

Because there are numerous ratios, it is easy to understand them in categories. Its categories are based on what performance is intended to detect.

You’re going to look at 5 types of categories. Each category measures a distinct aspect of the companies business.

5 Categories of financial ratios

  • Activity ratios
  • Liquidity ratios
  • Solvency ratios
  • Profitability ratios
  • Valuation ratios

Activity Ratios

Activity ratios measure how efficiently a company managed its daily operations. Such as the management of inventory and collection of the receivables.

It is the indicator of operational performance—how assets are used and managed by the company.

Types of Activity Ratios

Receivable Turnover Ratio: Receivable turnover ratio indicates how fast a company receives its cash from customers to whom it offers credit.

A high inventory turnover ratio indicates highly effective inventory management. And a low inventory turnover ratio indicates slow-moving inventory.

The formula of receivable turnover is-

Receivable Turnover Ratio = Revenue / Average trade collectible

Payable Turnover Ratio: Payable turnover ratios states that how many times per year a company pays off its creditors.

A low payable turnover ratio indicates the company having trouble making its payments.

The formula of payable turnover ratio is-

Payable Turnover Ratio = Purchases / Average Trade Payable

Liquidity Ratios

The liquidity ratios measure a company’s ability to meet its short-term debt obligations. In a nutshell, it’s the ability to pay the short-term debt.

The higher the liquidity ratio, the higher the liquidity of the company.

Types of liquidity ratios

Current Ratio: Current ratio express current assets to current liabilities. It indicates its ability to meet short-term obligations by current assets.

A lower ratio indicates less liquidity. Conversely, a higher ratio indicates higher liquidity.

The formula of the current ratio is-

Current Ratio: Current Assets / Current Liabilities

Quick Ratio: The Quick ratio only includes highly liquid assets to current liabilities. Like the current ratio, a lower quick ratio indicates less liquidity. Conversely, a higher quick ratio indicated greater liquidity.

It is a better indicator than a current ratio for checking out a company’s liquidity.

The formula of quick ratio-

Quick Ratio: Cash + Short-term Marketable Investments + Reciveables / Current Liabilities

Solvency Ratios

Solvency ratios measure a company’s ability to meet its long-term debt/obligations. Obligations of the company are to make interest and principal payments.

Types of solvency ratios

Debt to Assets ratio: The debt to asset ratio measures the percentage of total assets financed with debt. For example, a ratio of 0.30 indicates 30 percent of the company’s assets are financed with debt.

The higher ratio indicates weaker solvency.

The formula of debt to assets ratio-

Debt to Assets Ratio = Total Debt / Total assets

Debt to Equity Ratio:  The debt to equity ratio measures the amount of equity relative to the amount of debt. A higher ratio indicates weaker solvency.

The ratio of 1 indicates the company has an equal amount of debt and equity.

The formula of debt to equity ratio-

Debt o Equity Ratio = Total debt / Total equity

Profitability Ratios

Profitability ratios measure the company’s profit earned during its accounting period. The ability to generate profit on invested capital is key to a company’s overall value.

Therefore, while analyzing a stock or companies creditworthiness consider checking profitability ratios.

Types of profitability ratios:

Net Profit Margin:Net profit is calculated as revenue minus all expenses. Net profit margin is a percentage of profit relative to its revenue.

A higher ratio indicates greater profitability.

The formula of net profit margin is-

Net Profit Margin = Net Profit / Revenue

Return on Assets: Return on assets measures the profit earned by a company on its assets. The higher the ratio, the more profit is generated by a given level of assets.

Return on Assets = Net Income / Average Total Assets

Valuation ratios

Valuation ratios, sometimes called multiples measure the quantity of an assets associated with ownership of a specified claim. These ratios are mostly used by investors.

The P/E ratio is the most famous and widely used in the stock market.

Types of valuation ratio are-

Price to Earnings Ratio: The P/E ratio tells that how much money investors pay to earn one rupee. For example, the p/e of 10 indicates you need to pay 10 rupees to earn 1 rupee.

The formula of price to earnings ratio-

Price to Earnings Ratio = Price Per Share / Earning Per Share

Dividend Payout Ratio: The dividend payout ratio measures the percentage of earnings attributable to stakeholders/shareholders.

For example, the 40 ratio indicates 40 percent of the amount is attributable to investors from earnings.

The formula of dividend payout ratio is-

Dividend Payout Ratio: Common Share Dividends / Net Income Attributable to Common Shares

Conclusion

Although there are lots of ratios, we looked at some ratios of each category. You don’t need to calculate the ratio by yourself. There are platforms that already have ratios or you can make them by yourself. One that I use most is Screener.

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