Overview:

Financial ratios are the tool that uses to assess an entity’s financial healthiness. There are many types and classes of financial ratios that use or tailor based on their requirement.

For example, profitability ratios are the group of financial ratios that use to assess an entity’s profitability by comparing certain performance again competitors as well as resources that use. Some financial ratios are uses to assess the financial healthiness or the financial position of the entity.

The following are the list of group of financial ratios that normally use by analyst along with the useful information that you should know about the ratio:

8 Profitability Ratios:

  1. The gross margin ratio is calculating by dividing gross profit over sales of the period. A high-profit margin indicates that an entity spends less than a competitor on the direct cost of products or services. Some entities set the strategy to make the loss low by increasing production volume.
  2. The operating income ratio is calculating by dividing net operating income over net sales. This ratio helps the entity to assess whether the operating cost it spends more than the competitor or at an acceptable rate. An entity might need to study its operation cost and operating activities if the ratio is not favourable.
  3. Net margin ratio: net profit margin is one of the most important profitability ratios that could help an entity to assess how well the entity spends on operating costs and other related costs. This margin is different from the gross profit margin because the gross profit margin studies only the cost of goods sold (cost related to product or services).
  4. The effective tax rate is calculated by dividing income taxes expense over the profit before taxes.
  5. Return on total assets is calculated by dividing profit before interest and tax over net assets. This ratio is used to assess the ability of that entity could generate profit from using net assets. Sometimes it is used to assess management leadership.
  6. Return on equity is calculated by dividing net income over shareholder equity. This ratio assesses the ability that shareholders could earn from its invested fund. This ratio is quite important for investors and shareholders.
  7. DuPont Analysis is the deep analysis of Return on Equity by using the relationship between Profit Margin, Assets Turnover, and Equity multiplier.
  8. Economic value added (EVA) is basically assessing how well the projects have added value to shareholders and the company.

Usages:

The analyst uses these groups of ratios to assess how well an entity could generate profits from using certain resources as well as expenses.

For example, an analyst using a return on assets to assess the ability of that an entity to generate income from the assets that it has on hand.

Gross profit margin is also one of the important profitability ratios that popularly use to assess how well an entity generates income from the product before considering the operating cost. This might help an entity to assess the costing and production problems.

This group of financial ratios could not be used alone. To gain a better understanding of an entity’s financial situation and to get a better result on assessment, analysts should use these groups of financial ratios along with other financial ratios as well as non-financial information.

Analysts should also compare the profitability ratios in different periods, and against competitors. Sometimes, compared with the set KPI also helps the analyst or other users to see how well the performance of an entity financially compares to others.

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7 Efficiency Ratio:

  1. Account Receivable Turnover: This ratio measures how well the entity manages its account receivable. The better management on account receivable indicates that the entity assets (a/r) are efficiently used.
  2. The working capital ratio is the liquidity measurement ratio by using the relationship between current assets and current liability.
  3. Assets turnover ratio is used to assess the usage and management of an entity’s assets to generate revenues. The ratio indicates that assets are effective and generate better income.
  4. Fixed assets turnover ratio. This ratio specifically assesses the efficiency of fixed assets. The high ratio indicates that the entity well manages its fixed assets. The manufacturing company prefers to use this kind of ratio to perform efficiency ratio assessment.
  5. Inventory turnover ratio is the important efficiency ratio, especially for manufacturing companies. This ratio use cost of goods sold and averages inventories to assess how effectively an entity manages its inventories.
  6. Days’ sales in inventory are the ratio used to assess an entity’s performance in managing its inventories into actual sales. This ratio is very important for the management team and especially for potential investors to review among others efficiency ratio. This ratio is calculated as the number of days.
  7. Account payable turnover uses to determine the rate the entity pays off its suppliers. Three main elements that use to calculate this ratio credit purchase from suppliers, cost of sales, and averages account payable during the period.

Usages:

Efficiency ratios are the group of financial ratios that use to assess how well an entity could manage its assets and liability maximize sales, profit and add value to the company.

These group of financial ratios do not look only into the ways how well an entity manage its assets but they also assess how well the liabilities are managed.

For example, the account receivable turnover ratio assess how efficiently an entity manages its accounts receivable while the account payable turnover assess how well account payable are managed.

Some analyst use only assets turnover ratio to perform efficiency ratio assessment however some analyst use not only this ratio but also fixed assets turnover ratio to specifically assess the efficiency of fixed assets.

Another thing that we need to consider when interpreting these ratios is the conflict between numbers of ratio with liability turnover or payable turnover ratio. A small amount of this ratio may interpret in two ways.

One is entity might be good at managing its payable and the other is entity might not be good at negotiating with its supplier and most of them do not provide credit term to company.

5 Liquidity Ratios:

Liquidity ratios are the group of financial ratios that measure an entity financial ability to pay its short term debt. There are many variety ratios including current ratio, quick ratio, defensive interval ratio, cash ratio, and working capital ratio. There are two main components that use for calculating these ratios are liquid assets and liquid liability.

  1. The current ratio is one of the most important liquidity ratios. This ratio uses the relationship between current assets and current liability to measure the entity liquidity problem of the entity. If the ratio is below, that mean current assets is higher than the current liability. This indicates that an entity could use its current assets to pay off the current liability. Entity liquidity position assumes to be good.
  2. Quick ratio removes certain current assets from its calculation. Those assets include inventories and account receivable. This ratio treat inventories and account receivable as the current assets that could not convert into cash quickly.
  3. The defensive interval ratio is similar to the cash ratio and quick ratio. This ratio assesses the possible period that an entity could run by using only current assets.
  4. Cash Ratio uses the entity current assets such as cash and other cash equivalent compare to the current liability that the entity has. A high cash ratio means that entity has a large amount of cash
  5. The working capital ratio is the liquidity measurement ratio by using the relationship between current assets and current liability. Working capital equal to current assets less current liability. The working capital ratio includes the current ratio and quick ratio.
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Usages:

Normally, these ratios are calculated and assess the analyst concern or want to know about the financial situation of the entity like when the loan is in consideration to be provided to the entity. These ratios are popular for analyst working in the bank as well as an investment company.

Auditors have also assessed this ratio to assess the entity going concerned. For example, the current assets ratio is used whether current assets could pay off current liability or not. If not, then the entity might indicate a liquidity problem.

4 Solvency Ratios:

Solvency Ratios are the group of financial ratios that analyst use to assess entity’s ability to remain solvent for its operation. The assessment period normally more than one year.

Most of the financial element that use for assessment are liquid assets and liquid liability. Potential investors, bankers, and creditors are the common users of these ratios. These ratios similar to liquidity ratios.

  1. The current ratio is one of the most important liquidity ratios. This ratio uses the relationship between current assets and current liability to measure the entity liquidity problem of the entity. If the ratio is below, that mean current assets is higher than the current liability. This indicates that an entity could use its current assets to pay of current liability. Entity liquidity position assumes to be good.
  2. Quick ratio removes certain current assets from its calculation. Those assets include inventories and account receivable. This ratio treat inventories and account receivable as the current assets that could not convert into cash quickly.
  3. The debt to Equity Ratio is used in both solvency and leverage ratio. It assesses the entity financial leverages by using the direct relationship between current entity liability and an entity’s equity. If the ratio is more than 100%, that means the current entity’s debt is more than equity and this could tell the investors that the entity’s financing strategy is weight more on debt.
  4. Interest Coverage Ratio uses the interest expenses for the period compared to profit before interest and tax for the period. The main idea of this ratio is to assess how well the entity current profit before tax could handle the interest. High debt to equity ratio entity might face a low-interest coverage ratio. And that means the entity face difficulty in paying its interest from its profits.
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5 Leverage Ratios:

  1. Total assets to equity are one of the financial ratios used to assess the entity financial leverages. This ratio us total assets at the end of a specific period compare to the total equity at the end of a specific period High assets to equity ratio mean that entity has more assets than its equity
  2. Debt to equity or some time it is called liability to equity ratio. This ratio compares an entity current liability or debt to its current equity. It assesses the entity financial leverages by using the direct relationship between current entity liability and an entity’s equity. If the ratio is more than 100%, that means the current entity’s debt is more than equity and this could tell the investors that the entity’s financing strategy is weight more on debt.
  3. Debt to assets is calculated by using total liability including current and non-current liability compare to total assets. If the ratio is high, the entity financing policy might aggressive on debt than an entity. And, this high ratio might indicate that entity could face difficulty to pay its debt by using all of its assets.
  4. Debt to capital determines the entity financial leverages by using both debt and capital. Debt and Capital are the main sources of entity finance and if the debt is too high compare to capital, the entity might spend a lot on paying the interest to the bank and creditor rather than paying a dividend to shareholders.
  5. Times interest earned or interest coverage ratio is the same. This ratio is used for the interest expenses for the period compared to profit before interest and tax for the period. The main idea of this ratio is to assess how well the entity current profit before tax could handle the interest. High debt to equity ratio entity might face a low-interest coverage ratio. And that means the entity face difficulty in paying its interest from its profits.

5 Activity Ratios:

  1. Receivables turnover. This ratio measure how well the entity manages its account receivable. The better management on account receivable indicates that the entity assets (a/r) are efficiently used.
  2. Inventory turnover is the importance of efficiency ratio, especially for a manufacturing company. This ratio use cost of goods sold and averages inventories to assess how effectively an entity manage its inventories.
  3. Days inventory is the ratio used to assess the entity’s performance in managing its inventories into actual sales. This ratio is very important for the management team and especially for potential investors to review among others efficiency ratio. This ratio is calculated as the number of days.
  4. Payable turnover uses to determine the rate the entity pay off its suppliers. Three main elements that use to calculate this ratio credit purchase from suppliers, cost of sales and averages account payable during the period.
  5. Fixed assets turnover. This ratio specifically assesses the efficiency of fixed assets. The high ratio indicates that an entity well manages its fixed assets. The manufacturing company prefer to use this kind of ratio to perform efficiency ratio assessment.