FINANCIAL REASONS: TYPES, WHAT THEY ARE FOR AND EXAMPLES - DUDAS - 2025

The financial ratios are key indicators of the financial performance of a company, created with the use of numerical amounts caught in the financial statements to obtain important information about an organization.

The numbers found in a company's financial statements, which are balance sheet, income statement, and cash flow statement, are used to perform quantitative analysis and evaluate liquidity, growth, margins, rates of return, leverage, profitability., and valuation of a company.

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When it comes to investing, analyzing financial statement information is one of the most important elements of the fundamental analysis process, if not the most important.

At the same time, the sheer number of numbers in a company's financial statements can be puzzling and intimidating to many investors. However, through the analysis of financial ratios, it will be possible to work with these numbers in an organized way.

Calculation and analysis

Calculating financial ratios is relatively straightforward. However, understanding and interpreting what they say about a company's financial health requires a bit more work.

Established companies often have several years of balance sheet and income statement data to work with the ratio analysis.

Calculating financial ratios for various periods, either quarterly or annually, helps to track useful trends in the company's operational performance.

Types and their characteristics

Liquidity ratios

They are financial ratios that measure the ability of a company to pay its short and long-term financial obligations. The most common financial liquidity ratios include the following.

Current ratio

The current ratio measures the ability of a company to pay short-term liabilities with current assets:

Current ratio = current assets / current liabilities.

Quick reason

Quick ratio measures the ability of a company to pay short-term liabilities with quick assets:

Quick ratio = (current assets - inventories) / current liabilities.

Operating cash flow ratio

It is a measure of the number of times that a company can pay current liabilities with the cash generated in a given period:

Operating cash flow ratio = operating cash flow / current liabilities.

Leverage ratios

They measure the amount of equity that comes from debt. In other words, financial leverage ratios are used to evaluate a company's debt levels. The most common financial ratios for leverage include the following:

Debt to asset ratio

It measures the relative amount of the assets of a company that are provided thanks to the debt:

Debt to assets ratio = total liabilities / total assets.

Debt to equity ratio

The debt-to-equity ratio calculates the weight of total debt and financial liabilities versus stockholders' equity:

Debt to equity ratio = Total liabilities / Shareholders equity.

Interest coverage ratio

The interest coverage ratio determines how easily a business can pay its interest expenses:

Interest coverage ratio = operating income / interest expense.

Debt service coverage ratio

The debt service coverage ratio determines the ease with which a business can pay its debt obligations:

Debt service coverage ratio = operating profit / total debt service.

Efficiency reasons

They are also known as financial activity indices. They are used to measure how well a company is using its assets and resources. The most common financial efficiency ratios include the following.

Asset turnover ratio

The asset turnover ratio measures the ability of a company to generate sales from assets:

Asset turnover ratio = net sales / total assets.

Inventory turnover ratio

It measures how many times a company's inventory is sold and replaced in a given period:

Inventory turnover ratio = cost of merchandise sold / average inventory.

Accounts receivable turnover ratio

Measures the number of times a business can convert accounts receivable to cash during a given period:

Accounts Receivable Turnover Ratio = Net Credit Sales / Average Accounts Receivable.

Sales days in inventory

The sales days in inventory ratio measures the average number of days a company keeps in inventory before selling it to customers:

Days of sales in inventory = 365 days / inventory turnover ratio.

Profitability reasons

They measure a company's ability to generate income relative to revenue, balance sheet assets, operating costs, and capital. The most common financial profitability ratios include the following.

Gross profitability ratio

Compare a company's gross profit to its net sales to show how much profit a company makes after paying the cost of merchandise sold:

Gross profitability ratio = gross profit / net sales.

Operating profitability ratio

The operating profitability ratio compares a company's operating income to its net sales to determine operating efficiency:

Operating profitability ratio = operating profitability / net sales.

Return on Assets Ratio

The return on assets ratio measures the efficiency with which a company uses its assets to generate profits:

Ratio of return on assets = net return / total assets.

Ratio of profitability over equity

The profitability-to-equity ratio measures the efficiency with which a company uses its equity to generate profits:

Ratio of return on equity = net return / shareholders' equity.

Market value ratios

They are used to evaluate the price of a company's shares. The most common market value ratios include the following.

Book value per share ratio

The book value per share ratio calculates the value per share of a company based on the capital available to shareholders:

Ratio of book value per share = stockholders' equity / Total shares outstanding.

Dividend yield ratio

The dividend yield ratio measures the amount of dividends attributed to shareholders relative to the market value per share:

Dividend yield ratio = dividends per share / share price.

Earnings per share ratio

The earnings per share ratio measures the amount of net income earned for each outstanding share:

Earnings per share ratio = net earnings / total shares outstanding.

Price-earnings ratio

The price-earnings ratio compares the price of a company's stock to earnings per share:

Price-earnings ratio = Share price / Earnings per share.

What are financial ratios for?

Financial ratios are the most common and widespread tools for analyzing the financial situation of a company. The reasons are easy to understand and easy to calculate. They can also be used to compare different companies in different industries.

Since a ratio is simply a mathematical comparison based on proportions, both large and small businesses can use ratios to help them compare their financial information.

In a way, financial ratios do not take into account the size of a company or industry. The ratios are just a rough estimate of financial position and performance.

Financial ratios allow companies from all industries, sizes, and sectors to be compared to identify their strengths and weaknesses.

Company performance tracking

The determination of financial ratios is carried out individually by period, as is the monitoring over time of changes in their values ​​to discover trends that may be developing in a company.

For example, an increase in the debt-to-asset ratio may show that a business is burdened with debt and may eventually face a risk of default.

Make comparisons of company performance

Comparing the financial ratios with those of the main competitors is done to verify whether the company relative to the industry average is performing better or worse.

For example, comparing the return on assets between companies makes it easier for an investor or analyst to determine which company assets are being used most efficiently.

Users

Users of financial ratios include both internal and external parts of the company:

- Internal users are the owners, the management team and employees.

- External users are retail investors, financial analysts, competitors, creditors, regulatory authorities, tax authorities and also industry observers.

Examples

The analysis of financial statements includes financial ratios. For the ABC company its balance sheet and income statement are presented:

Here are two financial ratios that are based solely on the current asset and current liability amounts that appear on ABC Company's balance sheet:

Current ratio = current assets / current liabilities = $ 89,000 / $ 61,000 = 1.46.

Quick ratio = (current assets - inventories) / current liabilities = ($ 89,000 - $ 36,300) / $ 61,000 = $ 52,700 / $ 61,000 = 0.86.

The following financial ratio implies the relationship between two balance sheet amounts: total liabilities and total capital:

Debt to equity ratio = Total liabilities / Shareholders' equity = $ 481,000 / $ 289,000 = 1.66.

In this example, for every $ 1 contributed by shareholders, creditors contributed $ 1.66.

Financial reasons with the income statement

The following financial ratios relate the balance sheet amounts of accounts receivable and inventory to amounts in the income statement. To illustrate these financial ratios, we have the following income statement:

Inventory turnover ratio = cost of merchandise sold / average inventory = $ 380,000 / $ 36,300 = 10.47 times.

Accounts Receivable Turnover Ratio = Net Credit Sales / Average Accounts Receivable = $ 500,000 / $ 40,500 = 12.35 times.

References

1. CFI (2019). Financial Ratios. Taken from: corporatefinanceinstitute.com.
2. Richard Loth (2019). Financial Ratio Tutorial. Taken from: investopedia.com.
3. My Accounting Course (2019). Financial Ratio Analysis. Taken from: myaccountingcourse.com.
4. Inc (2019). Financial Ratios. Taken from: inc.com.
5. Harold Averkamp (2019). Financial Ratios (Explanation). Accounting Coach. Taken from: accountingcoach.com.
6. Rosemary Peavler (2018). Financial Ratio Analysis Offers Valuable Business Insights. The Balance Small Business. Taken from: thebalancesmb.com.