Financial Ratios: Meaning, Types, and Importance for Investors

Before making any stock investments, investors must gauge the financial health of companies. Broadly speaking, this assessment can be conducted by analysing a company’s qualitative and quantitative characteristics. Qualitative factors include aspects like the company’s management quality, brand reputation, and industry position. Assessment of quantitative factors, on the other hand, involves mathematical analysis of the company’s key financial metrics. Combined, these factors give us a clearer picture of a company’s performance, long-term stability, and growth potential.

Financial ratios in particular are great tools for analysing the quantitative side of a company and can help investors make unbiased and more educated decisions. Let’s understand what a financial ratio is and have a look at its different types.

What are Financial Ratios?

To quantitatively analyse a company’s financial strength, investors use its three major financial statements – The balance sheet, income statement, and cash flow statement. These statements contain loads of essential numerical data about the company’s assets, liabilities, revenues, expenses, and cash flow. Financial ratios are simply formulas derived from financial statement data which are used to get meaningful information about a company’s profitability, margins, leverage, growth, liquidity, valuation, and many other aspects.

These ratios help investors understand whether or not a company is worth investing in. Some common examples of financial ratios are the price-to-book ratio (P/B ratio), the price-to-earnings ratio (P/E ratio), and the debt-to-equity ratio.

Now that you know the definition of financial ratio, it’s time to understand its various types.

Types of Financial Ratios

There are dozens of financial ratios that are commonly used by investors and analysts. These individual ratios can be classified broadly into five categories, which are liquidity ratios, profitability ratios, leverage ratios, efficiency ratios, and valuation ratios. Let’s look at each of the categories of financial ratio in detail:

1. Liquidity Ratios

Companies often take debt to fund operations, expand, or invest in new projects. However, managing debt is very important for companies as high debt levels without sufficient cash flow can lead to financial disasters. Liquidity ratios help measure a company’s ability to meet its short-term and long-term obligations using its quick or current assets. Investors use liquidity ratios to determine how well companies can meet these immediate financial demands without having to rely on external financing. Some examples of liquidity ratios are:

1. Acid-test Ratio

This ratio is also known as the quick ratio as it helps determine a company’s ability to pay off debt using quick assets. It is given by (current assets – inventory) / current liabilities.

2. Current Ratio

As the name suggests, this ratio measures the ability to meet short-term obligations with short-term or current assets. Its formula is current ratio = current assets / current liabilities.

3. Cash Ratio

This ratio indicates how easily a company can pay off debt using cash and cash instruments. It is calculated by dividing cash and cash equivalents by current liabilities.

As you can see, all these ratios measure current assets relative to current liabilities. When a company has more assets than liabilities, the ratio is higher, that’s why for investors a higher liquidity ratio means that a company is financially healthy in the short term.

2. Profitability Ratios

Profitability is the endgame for any business, so these ratios are an important indicator of a company’s long-term success. They give investors a look into how well a company can generate profits relative to its operational costs, revenue, assets, and equity. Some common types of profitability ratios are:

1. Net Profit Ratio

This ratio compares a company’s net income, that is, its profit after subtracting all expenses, to its revenue. The higher the net profit, the more efficient the business.

2. Return on Assets Ratio

The ROA ratio is used to determine how well a company is using the assets at its disposal to make a profit. ROA is given by net income / total assets.

3. Return on Equity Ratio

Instead of assets, the ROE uses the shareholders’ equity to assess profitability. It is calculated as net income / shareholder equity.

4. Operating Margin Ratio

Used to evaluate a company’s operating effectiveness, this ratio compares operating income to net sales. That’s why this ratio is also called the return on sales ratio. Operating margin ratio = operating income / net sales.

3. Leverage Ratios

These types of financial ratios are also called solvency ratios, and they measure how much debt a company has taken on compared to its earnings, equity or assets. If a company takes on too much debt, there is a real risk of them struggling to meet their obligations in the long term, especially during downturns or periods of low cash flow. That’s why investors use solvency ratios to gauge the level of debt-related risk associated with their investment and determine if a company’s debt levels are manageable and sustainable in the long run. Here are some types of commonly used leverage ratios:

1. Debt Ratio

This is the simplest solvency ratio, which compares a company’s total liabilities to its total assets. Given by total liabilities / total assets.

2. Debt to Equity Ratio

Companies often use shareholder equity to finance operations and expansions. This ratio measures a company’s total liabilities to shareholder equity. Calculated by dividing total liabilities by shareholder equity.

3. Debt Service Coverage Ratio

Calculated using operating income / total debt service, this ratio helps measure a company’s ability to cover its debt obligations from the income it generates through its core operations.

4. Interest Coverage Ratio

This ratio indicates how easily a company can use its operating income to meet its interest obligations. The interest coverage ratio is given by operating income / interest expenses.

4. Efficiency Ratios

Higher efficiency means higher profitability. Also called activity ratios, these types of financial ratios are used to measure how well a company uses the assets at its disposal to generate revenue. Some important efficiency ratios include:

1. Asset Turnover Ratio

Measures how efficiently a company uses its assets to generate sales. Asset turnover ratio can be derived by net sales / total assets.

2. Inventory Turnover Ratio

This ratio tells investors how many times the inventory is sold and replaced over a given period. It can be calculated by dividing the cost of goods sold by average inventory.

3. Day’s Sale in Inventory Ratio

This ratio gives a clear picture of the average number of days it takes for a company to sell its inventory to customers completely during a specific period, for example, quarters or festive seasons.

These ratios are important as they indicate how well a company runs its operations. They can reveal how sustainable a company’s daily operations are.

5. Valuation Ratios

Valuation ratios are the most commonly used financial ratios by investors, as they are used to assess the market value of a stock. They can give insight into whether a stock is overvalued, undervalued, or selling at a fair price. Take a look at some common market valuation ratios:

1. Dividend Yield Ratio

This ratio simply measures the annual dividend income an investor earns compared to the price of the company’s stock. It is calculated by dividend per share / share price. Multiplying this ratio by 100 will give you the stock’s dividend yield.

2. Book Value Per Share Ratio

This ratio calculates the per-share value of a company based on its equity available to common shareholders. The formula to calculate book value per share is (shareholder’s equity – preferred equity) / total outstanding shares.

3. Earnings Per Share Ratio (EPS)

You can derive EPS by dividing a company’s net income by its total outstanding shares. This metric is one of the most commonly used by investors when selecting stocks as it gives information on the profitability of a company on a per-share basis.

4. Price to Earnings Ratio (P/E)

The P/E ratio is used to measure the price of a stock relative to its earnings per share. If a company’s P/E is high, it means that the company may be overvalued. On the other hand, undervalued companies have lower P/E ratios.

Why Financial Ratios Matter for Investors

Besides giving quick, convenient, and objective insights into a company’s financial health, financial ratios allow investors to make comparisons on two fronts –

• Tracking a company’s performance using past financial ratios – Investors can use a company’s old financial ratios and measure them against the latest financial ratios to understand how the company has evolved during specific periods.
• Comparing a company with other companies in the same industry – Investors can also use financial ratios to understand how good or bad a company is doing relative to its competition or the industry as a whole.

Example of Financial Ratio Analysis

Financial ratios don’t have much meaning on their own. Instead, these figures should be compared to other information, such as the ratios of other companies in the same sector, and historical financial ratios of the same company to figure out how well a company is performing compared to its competitors and its past performance.

Here’s a tiny example of financial ratio analysis. If you compare a company’s current debt ratio to its debt ratio from a year ago, you can see whether the company is taking on more debt or paying it down over time. This trend can help you assess whether the company is becoming more financially stable or more leveraged. Similarly, you can compare these ratios with competitors or the industry averages to identify how well the company is managing its debt compared to its peers. Through financial ratio and analysis, investors can easily identify trends that impact a company’s financial health, but it’s important to make sure that the comparisons are valid.

Let’s take another example. Suppose you read that a company generated a revenue of Rs. 50 crores in a year. At a glance, you may think it’s impressive, but that may not tell the whole story. You’ll need to check a number of other factors as well, such as how much profit they made, how much debt they have, and their overall expenses. You will also need to compare this revenue to previous years’ figures, and how much revenue their competitors made. Financial ratios can help you gauge all this easily, quickly, and objectively.

Advantages of Using Financial Ratios

Assessing financial ratios can be very rewarding for investors for a number of reasons:

• A company’s financial statements, such as the balance sheet, cash flow statement, and income statement can be quite large and can take a lot of time to assess. Financial ratios give investors an easy way to evaluate a company’s financial health quickly.
• Comparing a company’s old financial ratios to its current ones can paint a picture of the company’s progress. Investors can easily gauge if the company has improved, deteriorated, or stagnated, and how well it is tracking forecasts and trends.
• Financial ratios can also be used to compare a company with other companies in the same industry. This can help investors evaluate how well it is doing relative to its competition and industry average.
• Financial ratios are purely quantitative, so they can take some emotions or biases out of investing and help investors make objective decisions.

Investors should also note that in spite of these benefits, financial ratio analysis is not without certain limitations. Most importantly, the effectiveness of the analysis depends on the knowledge and experience of the investor. For example, a company can possibly make small adjustments to its financial statements that makes its stock and ratios look better without there being any real effect on its actual financial health. In such cases, it’s easy for uninformed investors to be manipulated, which is why investors should have a deep knowledge of relevant financial ratios and understand what information they provide and don’t provide.

Conclusion

The world today runs on data. One of the most critical aspects that stock investing hinges on is how well investors can find useful information from the vast amounts of data available. Financial ratios are valuable metrics that allow investors to analyse a company’s health based on the quantitative data found in balance sheets, income statements and cash flow statements.

There are dozens of financial ratios, but they can broadly be categorised into five types – liquidity ratios, efficiency ratios, profitability ratios, solvency or leverage ratios, and valuation ratios. Each of these gives investors a unique perspective on how well a company is doing currently, how it can perform in the future, and how it’s holding up against its competitors. Through financial ratio analysis, investors can make informed and objective decisions.