How to do financial ratio analysis? Example and formula.

by Muhammad Ali

What is a financial ratio?

A financial ratio is used to calculate a company’s financial status or production against other firms. It is a tool used by investors to analyse and gain information about the finance of a company’s history or the entire business sector. To calculate financial ratios, numbers are taken from the balance sheet, income statement, and cash flow statement. 

The financial ratio is not a calculation but an explanation of the economic status of a company, in terms of profit, liquidity, leverage, and market valuation. A ratio may serve as an indicator, red flag, or clue for various issues.

What is ratio analysis?

Ratio analysis is an accounting method that uses financial statements, like balance sheets and income statements, to gain insights into a company’s financial health. Ratio analysis will help determine various aspects of an organization, including profitability, liquidity, and market value.

Ratio analysis is a helpful tool to determine from the outside what is going on inside a business because the financial statements required to perform ratio analysis are available to the general public. Company insiders typically do not use ratio analysis because they already have access to much more detailed information that will give them a better view of the company’s financial status.

Types of Financial Ratios

There are five types of financial ratio that can be use for ratio analysis. 

1.  Profitability Ratios

Profitability ratios reflect an entity’s profit compared to other businesses in the industry or over time. They reveal whether a firm’s ability to generate profits increases compared to previous periods. There are several types of profitability ratios, including:

  • Gross profit margin
  • Operating profit margin
  • Pre-tax margin
  • Net profit margin

These multiples can provide information on the company’s cost structure when viewed as a group.

2.  Efficiency Ratios

Efficiency (activity) ratios evaluate how efficiently a company manages its normal business operations. This indicates the firm’s ability to leverage its resources to maximize earnings.

Important efficiency ratios include:

  • Receivables turnover
  • Payables turnover
  • Working capital turnover
  • Inventory turnover
  • Days of sales outstanding
  • Days of payables
  • Days of inventory on hand
  • Cash conversion cycle

3.  Liquidity Ratios

Liquidity ratios gauge a firm’s ability to meet its short-term obligations and repay its debts using its assets. They show how exposed the company is to  liquidity shortages. The key liquidity financial ratios include the following:

  • Current ratio
  • Quick ratio
  • Cash ratio
  • Defensive interval

4.  Solvency Ratios

Solvency (financial leverage) ratios reveal a company’s ability to meet its long-term obligations. They compare a firm’s debts to its assets, equity, and earnings.

The most important solvency financial ratios include the following:

  • Debt-to-equity
  • Debt-to-assets
  • Debt-to-capital
  • Interest coverage
  • Fixed-charge coverage
  • Financial leverage

5.  Market Prospect Ratios

Market Prospect  (Valuation) ratios measure the relationship between a company’s intrinsic value or owners’ equity and some fundamental financial metric. Investors use this financial ratio analysis to predict earnings and future performance.

The most important valuation ratios include the following:

  • Earnings per share (EPS)
  • Price-earnings ratio (P/E)
  • Dividend yield
  • Retention rate
  • Dividend payout ratio

Find the most common financial ratios’ formulas and interpretations in our free Financial Ratios at a Glance cheat sheet.

Financial Ratio analyses example

Examples of ratio analyses

To better understand the different types of these ratios, consider the following example calculations:

  • Profitability ratios

The profitability ratio known as the net profit margin is the ratio of a company’s net income to its revenues. The net profit margin tells you how well a company turned its revenue into profit and allows investors to assess a company’s financial health and stability. The net profit margin formula is: 

(Net profits / Net sales) x 100 = Net profit margin

If a company has a revenue of $10,000 and made a net profit of $2,000, you can calculate its net profit margin as follows:$2,000 / $10,000 = 0.20 or 20%This results in a net profit margin of 20%.

  • Liquidity ratios

One of the common liquidity ratios is the current ratio, which determines whether a company can pay off its current liabilities with its current assets. The higher the current ratio, the better chance they have at doing this. 

The current ratio is: Current ratio = Current assets / Current liabilities

Say a company has current assets amounting to $50 and current liabilities of $20. Using the current ratio formula, you’d perform the following calculation:$50 / $20 = 2.5This results in a current ratio of 2.5. This means the company has $2.50 of current assets for every dollar of its current liabilities.

  • Leverage ratios

To better understand leverage ratios, you can use the debt-to-assets ratio as an example. This ratio helps business owners determine how much of the company’s total assets is financed through debt. 

The debt-to-assets ratio is:(Short-term debt + Long-term debt) / Total assets = Debt-to-assets

Now say your company’s total assets are $220,000 and the total debt accrued is $40,000. Based on this information, you’d perform the calculation as follows:$40,000 / $220,000 = 0.18 or 18%This means that 18% of your company’s assets are funded through debt.

  • Market value ratios

The price/earnings ratio or P/E ratio evaluates a business by comparing its current share price to its earnings per share. This ratio gives investors an idea of the relative value of a stock when compared to the P/E ratios of other companies. To calculate this value, you need to know the current stock price of a company, its number of outstanding shares and the profit the company has made. 

Here’s the price/earnings ratio: P/E Ratio = Market value per share / Earnings per share

Say a company’s stock price closed at $90, its profit for the fiscal year was $12 billion and its outstanding shares resulted in $3 billion. You can calculate its earnings per share by dividing its profit by its outstanding shares to get $4. Given this information, the company’s P/E ratio is: $90 / $4 = 22.50

  • Efficiency ratios

The efficiency ratio known as inventory turnover compares costs of goods sold to the average inventory as such:

Inventory Turnover = Cost of goods Sold / Average inventory

This ratio lets you know how much inventory a company has held and how efficiently it used its inventory. A high inventory ratio indicates that a company can move its inventory quickly. This displays good management and inventory control.Let’s say you have a company whose cost of goods sold amounts to $100,000 and that has a year-end inventory of $10,000. Using this information, you can determine its inventory turnover as follows:$100,000 / $10,000 = 10

In conclusion:

The financial ratio is not a calculation but an explanation of the economic status of a company, in terms of profit, liquidity, leverage, and market valuation. Ratio analysis is a helpful tool to determine from the outside what is going on inside of a business because the financial statements required to perform ratio analysis are available to the general public.

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