Financial ratios - a complete list
/What are Financial Ratios?
Financial ratios compare different line items in the financial statements to yield insights into the condition and results of a business. These ratios are most commonly employed by individuals outside of a business, since employees typically have more detailed information available to them. Nonetheless, senior managers must be conversant with the results of their key financial ratios, so that they can discuss the ratios with members of the investment community, creditors, and lenders.
Financial ratios can be used to compare companies within an industry, since they generally have approximately the same operating models and use roughly the same proportions of assets in relation to their sales volume. The result can be differences in market valuation, as investors reward those companies showing clearly better ratio results than their competitors. The reverse can also occur, where adverse financial ratios can trigger enough shareholder pressure that the board of directors may feel compelled to terminate the employment of the chief executive officer.
Financial ratios are typically divided into the classifications noted below.
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Performance Ratios
Performance ratios compare information on the income statement, and are designed to judge the ability of an organization to generate a profit. Commonly used ratios in this classification include:
Gross margin ratio. The formula is the gross margin, divided by sales. It is useful for evaluating the total profitability of a company’s products and services.
Operating income ratio. The formula is operating income, divided by sales. One can use it to evaluate the ability of a company’s core operations to generate a profit.
Net profit ratio. The formula is net profit, divided by sales. It is used to discern how well a business can generate a profit from both its operations and financial activities.
Liquidity Ratios
Liquidity ratios are used to estimate the ability of an organization to pay its bills, and are carefully watched by creditors and lenders. Commonly used ratios in this classification include:
Days sales outstanding. The formula is accounts receivable divided by annual sales, which is then multiplied by the number of days in the year. It is useful for determining how quickly a firm can collect receivables from its customers, which is partially based on the company’s credit-granting procedures.
Current ratio. The formula is current assets, divided by current liabilities. Ideally, a business wants to have several times more current assets than current liabilities, in order to be assured of paying its bills on time.
Quick ratio. The formula is current assets not including inventory, divided by current liabilities. This is a better way to evaluate the liquidity of a business than the current ratio when its inventory takes a long time to sell.
Cash Flow Ratios
Cash flow ratios strip away any misleading effects caused by the accrual basis of accounting to reveal the extent to which a business is generating cash. Commonly used ratios in this classification include:
Cash flow return on assets. The formula is net profit plus non-cash expenses, divided by total assets. The level of cash flow return reveals how efficiently management is employing company assets.
Cash flow from operations ratio. The formula is cash flow from operations, divided by net income. The level of cash flow return indicates how well company operations are being managed.
Cash reinvestment ratio. The formula is the increase in the gross amount of fixed assets plus or minus changes in working capital, divided by the aggregation of net income and non-cash expenses. A higher level of reinvestment indicates that management sees opportunities to profitably invest more cash in the business.
Return on Investment Ratios
Return on investment ratios reveal the amount of return earned by investors when they invest in a business. Commonly used ratios in this classification include:
Return on equity. This ratio reveals the amount of return earned on the shareholders' equity invested in a business. The measurement is commonly used by investors to evaluate current and prospective business investments. To calculate the return on equity, simply divide net income by the total amount of equity. The formula is:
Net income ÷ Equity = Return on equity
Return on assets. The return on assets compares the net earnings of a business to its total assets. It provides an estimate of the efficiency of management in using assets to create a profit, and so is considered a key tool for evaluating management performance. To calculate the return on assets, divide net profits by total assets to arrive at the return on assets. The formula is:
Net profits ÷ Total assets = Return on assets
Limitations of Financial Ratios
There are significant limitations on the use of financial ratios. First, the information used for a ratio is as of a specific point in time or reporting period, which may not be indicative of long-term trends. Second, the information in a ratio is highly aggregated, and tells little about the underlying dynamics of a business. And finally, the information reported in a ratio will vary, depending on the accounting policies of a business.