There are various types of financial ratios used in practice to analyze financial statements. Some of them are listed below:
- Liquidity Ratios
- Assets Management Ratios
- Debt Management Ratios
- Profitability Ratios
- Market Value Ratios
1. Liquidity Ratios
Liquidity ratios are financial ratios that measure a company’s ability to meet its short-term obligations using its current or liquid assets. These ratios indicate whether a firm has enough resources to cover its liabilities that are due within one year.
- These ratios focus on current assets and current liabilities.
The two primary ratios used to test the liquidity of a firm are:
- Current Ratio
- Quick Ratio
a. Current Ratio
- It is the quantitative relationship between current assets and current liabilities.
- Current assets are those assets which can be converted into cash within a year. Eg. cash and marketable securities, accounts receivable, inventories…..
- Current liabilities are those obligations that must be paid within a year. Eg. accounts payable, notes payable, accruals….
Current ratios is calculated as: Current ratio = Current Assets / Current Liabilities
Note: As a conventional rule, the current ratio of 2 times is considered as a standard of comparison. Less than 2 times is considered as low and indicates short-term financial difficulties.
b. Quick Ratio
- It is the quantitative relationship between quick assets and current liabilities.
- Quick assets includes all current assets except inventories and prepaid expenses.
- Current liabilities are those obligations that must be paid within a year. Eg. accounts payable, notes payable, accruals….
Quick ratios is calculated as: Quick ratio = Quick Assets / Current Liabilities
Note: As a rule of thumb, the quick ratio of 1 times is considered as a standard of comparison. Less than 1 time indicates short-term solvency position.
2. Asset Management Ratios (Activity Ratios or Efficiency Ratios)
Asset management ratios are financial ratios that evaluate how efficiently a company utilizes its assets to generate revenue. They show how well the management is using resources like inventory, receivables, and total assets.
Purpose: They reflect the firm’s operational efficiency and the effectiveness of asset utilization.
- Inventory Turnover = Cost of Goods Sold ÷ Average Inventory
→ Indicates how many times inventory is sold and replaced during a period. - Receivables Turnover = Net Credit Sales ÷ Average Accounts Receivable
→ Shows how quickly receivables are collected. - Total Asset Turnover = Net Sales ÷ Total Assets
→ Measures how efficiently total assets are used to generate sales.
3. Debt Management Ratios (Leverage Ratios or Solvency Ratios)
Debt management ratios are financial ratios that measure the extent to which a firm relies on borrowed funds (debt) for financing and its ability to meet long-term obligations. They reflect the firm’s financial leverage and risk.
Purpose: They help in assessing financial stability, capital structure, and the risk of insolvency.
- Debt-to-Equity Ratio = Total Debt ÷ Total Equity
→ Shows the relative proportion of debt and equity in financing the firm. - Debt Ratio = Total Debt ÷ Total Assets
→ Indicates the percentage of assets financed through debt. - Interest Coverage Ratio = EBIT ÷ Interest Expense
→ Measures the ability of the firm to pay interest from operating profits.
4. Profitability Ratios
Profitability ratios are financial ratios that measure a company’s ability to generate profit relative to its sales, assets, or equity. They provide insight into overall business performance and management efficiency.
Purpose: They show how effectively a company converts sales and investments into profit.
- Gross Profit Margin = (Gross Profit ÷ Net Sales) × 100
→ Indicates profitability after deducting cost of goods sold. - Net Profit Margin = (Net Profit ÷ Net Sales) × 100
→ Reflects overall profitability after all expenses, interest, and taxes. - Return on Assets (ROA) = Net Profit ÷ Total Assets
→ Shows how efficiently assets are used to generate profits. - Return on Equity (ROE) = Net Profit ÷ Shareholders’ Equity
→ Indicates the return earned on shareholders’ investments.
5. Market Value Ratios
Market value ratios are financial ratios that relate a company’s financial performance to its stock price in the market. They are primarily used by investors to assess the attractiveness of a company’s shares and its future growth potential.
Purpose: They reflect investor confidence, market perception, and valuation of the firm.
- Earnings Per Share (EPS) = Net Profit ÷ Number of Shares Outstanding
→ Shows the amount of profit attributable to each share. - Price-Earnings Ratio (P/E Ratio) = Market Price per Share ÷ Earnings per Share
→ Indicates how much investors are willing to pay for each unit of earnings. - Market-to-Book Ratio = Market Value per Share ÷ Book Value per Share
→ Compares market valuation of a company with its book value.
