What are the Ratios Used in Financial Analysis?

A number of ratios are used in financial analysis to measure the profitability and the overall financial health of the company in the short as well as in the long terms. These ratios are mainly used by the investors, owners of the company, and management. The short-term creditors are interested in the short-term liquidity of the firm whereas the long-term debtors seek long-term sustainability and profitability.

The owners of a firm are more concerned mainly in the profitability and growth of the firm. The management, on the other hand, is interested in all other financial aspects of the company. So, depending on these needs, a number of financial ratios are available to help in analyzing the conditions of the company.

In accordance with the needs of analysis, financial ratios can be broadly grouped into the following four categories −

• Liquidity ratios

• Leverage ratios

• Activity ratios

• Profitability ratios

Liquidity Ratios

Liquidity ratios imply a firm’s obligation and ability to meet the short term cash-needs. It is a short-term ratio, meaning that the validity of the ratio is for the short-term.

Liquidity Ratios include −

• Current Ratio − is given by Current Assets divided by Current Liabilities.

• Quick Ratio − It is given by Quick Assets (current assets - inventories) divided by Current Liabilities.

• Cash Ratio − It is given by Cash Assets (cash + Marketable securities) divided by Current Liabilities.

• Interval Measure − It is given by Quick assets divided by the Average Daily Expenses of the firm.

• Net Working Capital Ratio − It is given by Net Working Capital divided by Net Assets.

Leverage Ratios

Leverage ratios are used to assess the contribution of debts and equity in financing a firm’s assets.

Leverage Ratios include −

• Debt-Equity Ratio − The debt-equity ratio is given by Total Debt by Net Worth.

• TL-to-LF Ratio − It is given by Total Liabilities divided by Total Assets.

• LT-to-NW Ratio − It is given by Long-Term Debt divided by Net Worth.

Activity Ratios

Activity Ratios are connected with the performance of a company vis-a-vis the utility of the assets.

Activity Ratios can be divided into the following categories −

• Inventory Turnover − It indicates the efficiency of a firm in producing and selling its goods. It is given by the Cost of Goods Sold divided by the Average Inventory.

• Debtors Turnover Ratio − It is achieved by dividing Credit Sales by Average Debtors.

• Assets Turnover Ratio − It is obtained by dividing sales by Net Assets.

Profitability Ratios

Profitability is a much-revered item for all companies. So, the profitability ratios measure the overall efficiency and performance of a firm on both a long and short-term basis.

Profitability ratios are divided into the following categories depending on their nature and the elements used to get the ratios:

• Gross Profit Margin − It is a ratio that depends on Sales. It is obtained by dividing Gross Profit by Sales.

• Net Profit Margin − Net Profit Margin is obtained by dividing Net Profit by Sales.

• Operating Expenses Ratio − It is given by Net Operating Expense divided by Sales.

• Return on Investment (ROI) − It is obtained by using the terms Earnings Before Interests and Taxes (EBIT) and Total Assets (TA) in the case of Return on Total Assets and Net Assets (NA) for Return on Net Assets.

• Return on Equity (ROE) − Return on Equity is obtained by dividing Profit After Tax (PAT) by Net Worth (Equity).

Conclusion

All of the financial ratios mentioned above have different attributions and they are used to get insight into different aspects of the financial conditions of a firm.

Therefore, it is improbable that one ratio is more useful than the other. In fact, there may be a need to use more than one ratio to get a particular insight. Therefore, these ratios are all useful and equivalent in terms of utility.