Overview:

Financial ratios are the tool that use to assess entity’s financial healthiness. There are many types and class 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 entity’s profitability by compare certain performance again competitors as well as resources that use. Some of financial ratios are uses to assess financial healthiness or financial position of 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:

Profitability Ratios:

  1. Gross margin ratio is calculating by dividing gross profit over sales of the period. High profit margin indicate that entity spend less than competitor on direct cost of products or services. Some entity set the strategy to make the loss low by increasing production volume.
  2. Operating income ratio is calculating by dividing net operating income over net sales. This ratio help entity to assess whether the operating cost it spend more than competitor or at the acceptable rate. Entity might need to study it operation cost and operating activities if the ratio is not favor.
  3. Net margin ratio: net profit margin is one of the most importance profitability ratio that could help entity to assess how well entity spend on operating costs and others related cost. This margin is different from gross profit margin because gross profit margin study only cost of goods sold (cost related to product or services).
  4. 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 that entity could generate profit from using net assets. Sometime it is used to assess management leadership.
  6. Return on equity is calculate by dividing net income over shareholder equity. This ratio assess the ability that shareholders could earn from its invested fund. This ratio is quite importance for investors and shareholders.
  7. DuPont Analysis is the deep analysis on Return on Equity by using the relationship between Profit Margin, Assets Turnover, and Equity multiplier.
  8. Economic value added (EVA) is basically assess how well the projects are added the value to shareholders and the company.

Usages:

The analyst use these group of ratios to assess how well entity could generate profits from using certain resources as well as expenses. For example, analyst using return on assets to assess the ability that entity generate income from the assets that it has on hand.

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

These group of financial ratio could not be used alone. To gain better understanding about entity financial situation and to get better result on assessment, analyst should use these group of financial ratios along with others financial ratios as well as non-financial information.

Analyst should also compare the profitability ratios in different period, and against competitors. Sometime, compare with the set KPI is also help the analyst or others users to see how well the performance of entity financially compare to others.

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Efficiency Ratio:

  • Account Receivable Turnover: This ratio measure how well the entity manage its account receivable. The better management on account receivable indicate that the entity assets (a/r) is efficiently used.
  • Working capital ratio is the liquidity measurement ratio by using the relationship between current assets and current liability.
  • Assets turnover ratio is used to assess the usage and management of entity’s assets to generate revenues. The ratio indicate that assets are effectively and generate the better income.
  • Fixed assets turnover ratio. This ratio is specifically assess the efficiency of fixed assets. The high ratio indicate that entity is well manage its fixed assets. Manufacturing company prefer to use this kind of ratio to perform efficiency ratio assessment.
  • Inventory turnover ratio is the importance efficiency ratio especially for manufacturing company. This ratio use cost of goods sold and averages inventories to assess the how effectively entity manage its inventories.
  • Days’ sales in inventory is the ratio that used to assess entity’s performance in managing its inventories into actual sales. This ratio is very importance for management team and especially for potential investors to review among others efficiency ratio. This ratio is calculated as number of days.
  • Account payable turnover use to determine the rate the entity pay off its suppliers. Three main element 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 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 entity manage its assets but they also assess how well the liabilities are managed.

For example, account receivable turnover ratio assess how efficiently entity manage its accounts receivable while 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. Small amount of this ratio may interpret into two ways. One is entity might be good at managing its payable and others is entity might not be good at negotiating with its supplier and most of them do not provide credit term to company.

Liquidity Ratios:

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

  1. Current ratio is one of the most importance liquidity ratio. This ratio use the relationship between current assets and current liability to measure the entity liquidity problem of entity. If the ratio is below on, that mean current assets is higher than current liability. This indicate that entity could use its current assets to pay of current liability. Entity liquidity position assume to be good.
  2. Quick ratio remove 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. Defensive interval ratio is similar to cash ratio and quick ratio. This ratio assess the possible period that entity could run by using only current assets.
  4. Cash Ratio use entity current assets such as cash and others cash equivalent compare to current liability that entity have. High cash ratio mean that entity has large amount of cash
  5. 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. Working capital ratio include 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 financial situation of the entity like when the loan are in the consideration to be provided to entity. These ratios are popular for analyst working in the bank as well as investment company.

Auditors are also assess these ratio to assess entity going concern. For example, current assets ratio is used whether current assets could pay off current liability or not. If not, then entity might indicate as liquidity problem.

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.

  • Current ratio is one of the most importance liquidity ratio. This ratio use the relationship between current assets and current liability to measure the entity liquidity problem of entity. If the ratio is below on, that mean current assets is higher than current liability. This indicate that entity could use its current assets to pay of current liability. Entity liquidity position assume to be good.
  • Quick ratio remove 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.
  • 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 entity’s equity. If the ratio is more than 100%, that mean 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.
  • Interest Coverage Ratio use the interest expenses for the period compare 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 low interest coverage ratio. And that mean entity face difficulty in paying its interest from its profits.

Leverage Ratios:

  1. Total assets to equity is one of the financial ratios that use to assess the entity financial leverages. This ratio us total assets at the end of specific period compare to the total equity at the end of specific period High assets to equity ratio mean that entity have more assets than its equity
  2. Debt to equity or sometime it is called liability to equity ratio. This ratio compare 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 entity’s equity. If the ratio is more than 100%, that mean 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, entity financing policy might aggressive on debt than 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 determine 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, entity might spend a lot on paying the interest to bank and creditor rather than paying dividend to shareholders.
  5. Times interest earned or interest coverage ratio is the same. This ratio is used the interest expenses for the period compare 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 low interest coverage ratio. And that mean entity face difficulty in paying its interest from its profits.
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Activity Ratios:

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