Financial ratios are used to assess a company’s financial strength or weakness. Market ratios determine a company’s value as an investment, while liquidity ratios show the rate of assets that can be quickly converted into cash. Activity ratios measure how quickly assets can be turned into sales or cash, and debt ratios show how much of a company’s assets were paid for with borrowed money. Capital budget ratios determine the financial viability of a proposed project. Comparing financial ratios over time or with other companies in the industry is necessary for a valuable assessment.
A financial ratio is a metric used to determine a company’s strength or weakness in certain financial areas. Investors and analysts look at financial ratios to compare two or more companies in the same industry, or to analyze a company’s performance over time. A financial ratio is sometimes called an accounting ratio.
Market ratios are used to value a company or determine its value as an investment. The most basic of these is the price/earnings ratio, also called the P/E ratio. This financial ratio is the price per share of the company’s stock divided by earnings per share. Other ways to assess the value of the company include the book price, which is the price of the shares divided by the total assets less the intangible assets and liabilities; and the price to cash flow, which is the share price divided by the cash flow per share.
Profit margin is the rate of profitability, calculated by dividing net income by revenue. Operating margin, a financial ratio that reflects operating efficiency, is calculated by dividing operating income by net sales. Gross margin is a profitability ratio calculated as revenue less cost of goods sold divided by revenue. This is expressed as a percentage and measures how much money the company has left over after paying for the materials used in the goods it produces.
Liquidity ratios show the rate of a company’s assets that can be quickly converted into cash to pay off debt. The current ratio is the basic liquidity ratio, which shows how well the company can cover short-term obligations. This is current assets divided by current liabilities. With most credit transactions, the accounts receivable turnover ratio is an important liquidity ratio that shows how quickly the business is collecting money owed. This ratio is calculated as net credit sales divided by average accounts receivable.
Activity ratios show how quickly a company’s assets can be turned into sales or cash. The inventory turnover ratio, which is an activity ratio, shows how quickly the company sells its merchandise. It is calculated as the value of the inventory divided by the sales revenue.
Debt ratios include total debt to total assets, which is the broadest of these ratios. It is calculated by dividing short-term debt plus long-term debt by total assets. This ratio shows how much of the company’s assets were paid for with borrowed money. The interest coverage ratio is a debt ratio that shows a company’s ability to pay its debts. This is earnings before interest and taxes (EBIT) divided by the total interest payable.
Capital Budget Ratios are ratios that companies use to determine the financial viability of a proposed project. Net present value, which is the difference between the present value of cash inflows and the present value of cash outflows, is a capital budgeting ratio used for income-generating projects. The internal rate of return, which is the growth rate a project is expected to generate, is often used to compare several different projects under consideration.
For a financial index to be valuable, it must be compared to the same index for other companies in the industry, or for a single company over time. No single financial index will tell the whole story. However, they provide a solid basis for comparison when evaluating a company.
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