Last updated on October 16th, 2023 at 11:54 am
Ratios offer significant value to organisations aiming to track company performance. By comparing ratios over time or against industry benchmarks, stakeholders can identify trends, strengths, weaknesses, and other areas that might require attention. From performance management and strategy alignment to investor confidence and performance evaluation, financial ratio analysis can help an organisation in multiple ways.
With that being said, mentioned below is a detailed article exploring the various types of ratios and their fundamental role in the field of accounting and financial modelling.
What Is Financial Ratio Analysis?
Financial Ratio analysis can be defined as a quantitative method used to evaluate a company’s financial performance and health by examining the relationships between various financial data in its financial statement. It involves calculating and interpreting a variety of financial ratios, which are key indicators of different aspects of a company’s operations, profitability, efficiency, and liquidity.
Financial ratios can help to identify financial risks and vulnerabilities. For example, high debt ratios may indicate a risk of insolvency, whereas low liquidity ratios denote difficulties in meeting short-term obligations.
Different Types Of Financial Ratios
Some of the most commonly used ratios in financial modeling include,
Liquidity Ratios
Liquidity ratios are financial indicators utilised to assess a company's capacity to fulfil its immediate financial commitments by leveraging its readily available liquid assets. These ratios assess the company’s ability to convert assets into cash quickly without facing any significant loss in value. A few examples of such liquidity ratios are,
Current Ratio - The current ratio stands as one of the most commonly employed metrics for assessing liquidity. It is determined by dividing current assets by current liabilities.
Quick Ratio - Also referred to as an acid test, quick ratio is a more conservative measure of liquidity. The formula for the same involves removing inventory from current assets because they may not be easily converted into cash.
Cash Ratio - The cash ratio primarily focuses on a company’s cash and cash equivalents in relation to its current liabilities.
Solvency Ratios
Commonly referred to as financial leverage ratios, solvency ratios are financial indicators used to assess a company's enduring financial stability and its capability to fulfil long-term financial commitments. These ratios offer a comprehensive view of a company's capital makeup and its ability to service long-term debt obligations. Solvency ratios serve as a crucial parameter for investors and management to gauge the financial health and risks associated with the organisation’s long-term debt management.
A few examples of such solvency ratios include,
Debt-Equity Ratios - Debt-equity ratios compare the company’s total debt to its shareholder’s equity. It measures the proportion of a company’s financing that comes from debt relative to equity.
Debt Ratio - Much like the debt-equity ratio, the debt ratio represents the total debt as a proportion of total assets. This calculation entails dividing the total debt by the total assets.
Interest Coverage Ratio - This ratio is used to assess a company’s ability to cover its interest expenses with its operating income.
Profitability Ratios
Profitability ratios convey how well a company can generate profit in relation to its revenue, assets, equity, or other financial measures. These ratios provide insights into a company’s operational efficiency, effectiveness, and overall profitability. They not only help to identify areas of strengths and weaknesses in an organisation’s performance but also facilitate the decision-making process for improving profitability.
Investors and analysts use several profitability ratios to assess a company’s financial performance. A few examples of the same include,
Gross Profit Margin - This indicates the remaining percentage of sales revenue after you deduct the cost of goods sold (COGS). It denotes how efficiently a company produces and sells its products.
Operating Profit Margin - Also known as operating margin or return on sales, this ratio highlights the percentage of sales revenue after deducting COGS and operating expenses.
Return On Assets - Return on Assets (ROA) is an indicator of how efficiently a company utilises its assets to generate profit. It denotes the return on investment for all assets owned and financed by debt.
Apart from these, there are also several other types of financial ratios used by organisations. Such include efficiency, coverage, and market prospect ratios, among others.
Conclusion
Financial ratios serve as a concise way to communicate complex financial information. They help to bridge the gap between investors and management by providing a common language to discuss a company’s financial health. In addition to this, financial ratios also facilitate the strategic planning process.
Management can make more informed choices by understanding the financial implications of strategic decisions. If you wish to know more about financial analysts or simply wish to advance your career in finance, you can refer to multiple online finance certification courses.
One such among them includes the Financial Analysis course offered by Imarticus. Besides extending valuable insights from market leaders, this financial analysis course brings forth innumerable advantages, including unique real-world case studies, hands-on training by industry experts, an industry-approved curriculum, and more.
